<PAGE>
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PROSPECTUS MAY 1, 1994
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KEYSTONE TAX FREE FUND
200 BERKELEY STREET, BOSTON, MASSACHUSETTS 02116-5034
CALL TOLL FREE 1-800-343-2898
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Keystone Tax Free Fund (the "Fund") is a mutual fund that seeks the highest
possible current income, exempt from federal income taxes, while preserving
capital. The Fund invests primarily in municipal bonds. The Fund's net asset
value per share will fluctuate in response to changes in the market value of its
portfolio securities.
The Fund offers its shares by direct investment only to shareholders who
beneficially owned shares of the Fund on December 31, 1990. The Fund also offers
its shares through exchanges to shareholders of certain other Keystone Group
Funds.
Your purchase payment is fully invested. There is no sales charge when you buy
the Fund's shares. The Fund may impose a deferred sales charge, which declines
from 4% to 1%, if you redeem your shares within four years of purchase.
The Fund has adopted a Distribution Plan (the "Distribution Plan") pursuant to
Rule 12b-1 under the Investment Company Act of 1940 (the "1940 Act") under which
it bears some of the costs of selling its shares to the public.
This prospectus sets forth concisely the information about the Fund that you
should know before investing. Please read it and retain it for future reference.
Additional information about the Fund is contained in a statement of
additional information and appendix thereto dated May 1, 1994, which has been
filed with the Securities and Exchange Commission and is incorporated by
reference into this prospectus. For a free copy, or for other information about
the Fund, write to the address or call the telephone number listed above.
SHARES OF THE FUND ARE NOT DEPOSITS OR OBLIGATIONS OF, OR GUARANTEED OR
ENDORSED BY, ANY BANK, AND SHARES ARE NOT FEDERALLY INSURED BY THE FEDERAL
DEPOSIT INSURANCE CORPORATION, THE FEDERAL RESERVE BOARD, OR ANY OTHER AGENCY.
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TABLE OF CONTENTS
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<TABLE>
<CAPTION>
<S> <C> <S> <C>
Page Page
Fee Table ........................................ 2 How to Buy Shares ............................ 11
Financial Highlights ............................. 3 Distribution Plan ............................ 12
Fund Description ................................. 4 How to Redeem Shares ......................... 14
Fund Objective and Policies ...................... 4 Shareholder Services ......................... 15
Investment Restrictions .......................... 6 Performance Data ............................. 16
Risk Factors ..................................... 6 Fund Shares .................................. 17
Pricing Shares ................................... 6 Additional Information ....................... 17
Dividends and Taxes .............................. 7 Additional Investment Information............ (i)
Fund Management and Expenses ..................... 9
</TABLE>
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THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES
AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE
ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS
A CRIMINAL OFFENSE.
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<PAGE>
FEE TABLE
KEYSTONE TAX FREE FUND
The purpose of the fee table is to assist investors in understanding the
costs and expenses that an investor in the Fund will bear directly or
indirectly. For more complete descriptions of the various costs and expenses,
see the following sections of this prospectus: "Fund Management and Expenses";
"How to Buy Shares"; "Distribution Plan"; and "Shareholder Services."
SHAREHOLDER TRANSACTION EXPENSES
Contingent Deferred Sales Charge\1/ .................... 4.00%
(as a percentage of the lesser of total cost
or net asset value of shares redeemed)
Exchange Fee\2/ ....................................... $10.00
(per exchange)
ANNUAL FUND OPERATING EXPENSES\3/
(as a percentage of average net assets)
Management Fees ........................................ 0.43%
12b-1 Fees\4/ .......................................... 1.00%
Other Expenses ......................................... 0.17%
-----
Total Fund Operating Expenses .......................... 1.60%
=====
1 Year 3 Years 5 Years 10 Years
EXAMPLE\5/ ------ ------- ------- --------
You would pay the following
expenses on a $1,000
investment, assuming (1) 5%
annual return and (2)
redemption at the end of each
period:......................... $56.00 $70.00 $87.00 $190.00
You would pay the following
expenses on the same
investment, assuming no
redemption: .................... $16.00 $50.00 $87.00 $190.00
AMOUNTS SHOWN IN THE EXAMPLE SHOULD NOT BE CONSIDERED A REPRESENTATION OF PAST
OR FUTURE EXPENSES; ACTUAL EXPENSES MAY BE GREATER OR LESS THAN THOSE SHOWN.
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(1) The deferred sales charge declines from 4% to 1% of amounts redeemed within
four calendar years after purchase. No deferred sales charge is imposed
thereafter.
(2) There is no exchange fee for exchange orders received by the Fund over the
Keystone Automated Response Line ("KARL"). (For a description of KARL, see
"Shareholder Services.")
(3) Expense ratios are estimated for the Fund's fiscal year ending December 31,
1994.
(4) Long-term shareholders may pay more than the economic equivalent of the
maximum front end sales charge permitted by rules adopted by the National
Association of Securities Dealers, Inc. ("NASD"). In accordance with a new
rule adopted by the NASD, the Fund has limited its annual 12b-1 expenses to
1.00% commencing on July 8, 1993. For a further description of the Fund's
12b-1 expenses, see the "Distribution Plan" section of this prospectus.
(5) The Securities and Exchange Commission requires use of a 5% annual return
figure for purposes of this example. Actual return for the Fund may be
greater or less than 5%.
<PAGE>
FINANCIAL HIGHLIGHTS
KEYSTONE TAX FREE FUND
(For a share outstanding throughout the year)
The following table contains important financial information relating to the
Fund and has been audited by KPMG Peat Marwick, the Fund's independent auditors.
The table has been taken from the Fund's Annual Report and should be read in
conjunction with the Fund's financial statements and related notes, which also
appear, together with the auditor's report, in the Fund's Annual Report. The
Fund's financial statements, related notes, and auditors' report are included in
the statement of additional information. Additional information about the Fund's
performance is contained in its Annual Report, which will be made available upon
request and without charge.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
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1993 1992 1991 1990<F3> 1989 1988 1987 1986 1985 1984
----- ----- ----- ----- ----- ----- ----- ----- ----- -----
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
NET ASSET VALUE,
BEGINNING OF YEAR $ 8.04 $ 8.07 $ 7.90 $ 8.06 $ 8.18 $ 8.09 $ 8.85 $ 8.31 $ 7.57 $ 7.66
Income From Investment
Operations
Net Investment
Income ............ 0.39 0.46 0.46 0.52 0.57 0.55 0.56 0.68 0.70 0.72
Net Gains (Losses)
on Securities .... 0.48 0.12 0.36 (0.01) 0.15 0.30 (0.58) 0.88 0.81 (0.02)
Net Commissions Paid
on fund share sales<F1> -0- -0- -0- -0- -0- -0- -0- (0.08) (0.07) (0.07)
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Total from Investment
Operations ........ 0.87 0.58 0.82 0.51 0.72 0.85 (0.02) 1.48 1.44 0.63
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Less Distributions
Dividends from Net
Investment Income . (0.39) (0.46) (0.46) (0.52) (0.60) (0.63) (0.64) (0.68) (0.70) (0.72)
Distributions in
Excess of Net
Investment Income<F2> (0.06) (0.04) (0.07) (0.03) -0- -0- -0- -0- -0- -0-
Distributions from
Realized Capital
Gains -- Net ..... (0.33) (0.11) (0.12) (0.12) (0.24) (0.13) (0.10) (0.26) -0- -0-
Distributions In
Excess of
Realized Capital
Gains -- Net<F2>.. (0.01) -0- -0- -0- -0- -0- -0- -0- -0- -0-
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Total Distributions (0.79) (0.61) (0.65) (0.67) (0.84) (0.76) (0.74) (0.94) (0.70) (0.72)
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Net Asset Value: End
of Year .......... $ 8.12 $ 8.04 $ 8.07 $ 7.90 $ 8.06 $ 8.18 $ 8.09 $ 8.85 $ 8.31 $ 7.57
====== ====== ====== ====== ====== ====== ====== ====== ====== ======
TOTAL RETURN<F4>... 11.15% 7.55% 10.80% 6.66% 9.11% 10.89% (0.14%) 18.26% 19.96% 8.77%
RATIOS/SUPPLEMENTAL DATA
Ratios to Average Net Assets:
Operating and
Management Expenses 1.66% 1.38% 1.75% 1.18% 1.23% 1.79% 1.70% 0.83% 0.92% 1.08%
Net Investment
Income ............ 4.72% 5.71% 5.78% 6.54% 6.94% 6.74% 6.80% 7.79% 8.65% 9.41%
Portfolio Turnover
Rate .............. 76% 78% 77% 64% 69% 61% 43% 44% 55% 141%
Net Assets, End of
Year (thousands) ..$1,548,503 $1,453,199 $1,146,185 $1,060,826 $901,912 $903,132 $894,768 $1,025,084 $863,720 $336,774
<FN>
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<F1>Prior to June 30, 1987, net commissions paid on new sales of shares under the Fund's Rule 12b-1 Distribution Plan had been
treated for both financial statement and tax purposes as capital charges. On June 11, 1987, the Securities and Exchange
Commission adopted a rule which required for financial statements for the periods ended on or after June 30, 1987, that net
commissions paid under Rule 12b-1 be treated as operating expenses rather than capital charges. Accordingly, beginning with the
year ended December 31, 1987, the Fund's financial statements reflect 12b-1 Distributions Plan expenses (i.e., shareholder
service fees plus commissions paid net of deferred sales charges received by the Fund) as a component of net investment income.
<F2>Effective January 1, 1993 the Fund adopted Statement of Position 93-2: Determination, Disclosure, and Financial Statement
Presentation of Income, Capital Gains and Return of Capital Distributions by Investment Companies. As a result, distribution
amounts exceeding book basis net investment income (or tax basis net income on a temporary basis) are presented as
"Distributions in excess of net investment income." Similarly, capital gain distributions in excess of book basis gains (or tax
basis capital gains on a temporary basis) are presented as "Distributions in excess of realized capital gains." For the fiscal
years ended December 31, 1992, 1991 and 1990, distributions in excess of book basis net income were charged to paid-in capital.
<F3>Calculation based on average shares outstanding.
<F4>Excluding applicable sales charges.
</TABLE>
<PAGE>
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FUND DESCRIPTION
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The Fund is an open-end, diversified, management investment company,
commonly known as a mutual fund. The Fund has been operating continuously since
April 12, 1977 when it was created under Massachusetts law as a Massachusetts
business trust. The Fund is one of nineteen funds managed by Keystone
Management, Inc. ("Keystone Management"), the Fund's investment manager, and is
one of thirty funds managed or advised by Keystone Custodian Funds, Inc.,
("Keystone") the Fund's investment adviser. Keystone and Keystone Management are
from time to time also collectively referred to as "Keystone."
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FUND OBJECTIVE AND POLICIES
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The Fund's investment objective is to provide shareholders with the highest
possible current income, exempt from federal income taxes, while preserving
capital. The Fund invests substantially all and, under ordinary circumstances,
at least 80% of its assets in federally tax-exempt obligations, including
municipal bonds and notes and tax-exempt commercial paper (municipal bonds),
which are obligations issued by or on behalf of states, territories and
possessions of the United States ("U.S."), the District of Columbia and their
political subdivisions, agencies and instrumentalities, the interest from which
is, in the opinion of counsel to the issuers of such bonds, exempt from federal
income taxes, including the alternative minimum tax. Municipal bonds include
debt obligations issued by or on behalf of a political subdivision of the U.S.
or any agency or instrumentality thereof to obtain funds for various public
purposes. In addition, municipal bonds include certain types of industrial
revenue bonds issued by or on behalf of public authorities to finance privately
operated facilities. General obligation bonds involve the credit of an issuer
possessing taxing power and are payable from the issuer's general unrestricted
revenues. Their payment may be dependent upon an appropriation by the issuer's
legislative body and may be subject to quantitative limitations on the issuer's
taxing power. Limited obligation or revenue bonds are payable only from the
revenues of a particular facility or class of facilities or, in some cases, from
the proceeds of a special excise or other specific revenue source, such as the
user of the facility. Since the Fund considers preservation of capital as well
as the level of tax exempt income, the Fund may realize less income than a fund
willing to expose shareholders" capital to greater risk.
The Fund invests in municipal bonds only if, at the date of investment, they
are rated within the four highest grades by Standard & Poor's Corporation
("S&P") (AAA, AA, A and BBB) or by Moody's Investors Service, Inc. ("Moody's")
(Aaa, Aa, A and Baa) or, if not rated, are of comparable quality to obligations
so rated as determined by Keystone. Bonds rated Baa by Moody's are considered to
be medium grade obligations, i.e., they are neither highly protected nor poorly
secured. Interest payments and principal security appear adequate for the
present, but certain protective elements may be lacking or may be
characteristically unreliable over any great length of time. Such bonds lack
outstanding investment characteristics and have speculative characteristics as
well. Debt rated BBB by S&P is regarded as having an adequate capacity to pay
interest and repay principal. While it normally exhibits adequate protection
parameters, adverse economic conditions or changing circumstances are generally
more likely to lead to a weakened capacity to pay interest and repay principal
for debt in this category than in high rated categories. Keystone expects that
under normal circumstances at least 65% of the Fund's total assets invested in
municipal bonds within the three highest ratings of such services or, if not
rated, will be of comparable quality.
The Tax Reform Act of 1986 made significant changes in the federal tax
status of certain obligations that previously were fully federally tax-exempt.
As a result, three categories of such obligations issued after August 7, 1986
now exist: (1) "public purpose" bonds, the income from which remains fully
exempt from federal income taxes; (2) qualified "private activity" industrial
development bonds, the income from which, while exempt from federal income taxes
under Section 103 of the Internal Revenue Code ("the Code"), is includable in
the calculation of the federal alternative minimum tax; and (3) "private
activity" (private purpose) bonds, the income from which is not exempt from
federal income taxes. Investments in qualified "private activity" industrial
development bonds will be limited by the Fund's policy of investing no more than
20% of its total assets in securities which pay interest that is not exempt from
federal taxation. The Fund currently will not invest in "private activity"
(private purpose) bonds.
The Fund also may invest in securities that pay interest that is not exempt
from federal income taxes, such as corporate and bank obligations, obligations
issued or guaranteed by the U.S. government or by any of its agencies or
instrumentalities, commercial paper and repurchase agreements. Such securities
must be rated at least BBB by S&P or Baa by Moody's or, if not rated, must be
determined by Keystone to be of comparable quality. However, except for
temporary defensive purposes, the Fund will not invest more than 20% of its
total assets in such securities.
The Fund also may enter into reverse repurchase agreements and firm
commitment agreements for securities and currencies. The Fund may enter into
options transactions and may write covered call and put options, purchase call
and put options, including purchasing call and put options to close out existing
positions and purchase call options to fix the interest rates of obligations
held by it. The Fund may also employ new investment techniques involving such
options. In addition, the Fund may enter into currency and other financial
futures contracts and related options transactions for hedging purposes and not
for speculation and employ new investment techniques with respect to such
futures contracts and related options. In addition, the Fund may also invest in
obligations denominated in foreign currencies which are exempt from federal
income tax.
The ability of the Fund to achieve its investment objective is dependent
upon the continuing ability of issuers of municipal bonds to meet their
obligations to pay interest and principal when due. Obligations of issuers of
municipal bonds, including municipal bonds issued by them, are subject to the
provisions of bankruptcy, insolvency and other laws affecting the rights and
remedies of creditors, such as the federal Bankruptcy Act and laws, if any,
which may be enacted by congress or state legislatures extending the time for
payment of principal or interest, or both, or imposing other constraints upon
enforcement of such obligations. There is also the possibility that as a result
of litigation or other conditions, the power or ability of any one or more
issuers to pay, when due, principal and interest on its or their municipal bonds
may be materially affected. In addition, the market for municipal bonds is often
thin and can be temporarily affected by large purchases and sales, including
those by the Fund.
From time to time, proposals have been introduced before Congress for the
purpose of restricting or eliminating the federal income tax exemption for
interest on municipal bonds, and similar proposals may be introduced in the
future. If such a proposal were enacted, the availability of municipal bonds for
investment by the Fund and the value of the Fund's portfolio could be materially
affected, in which event the Fund would re-evaluate its investment objective and
policies and consider changes in the structure of the Fund or dissolution.
Investment in some securities may involve special considerations. For
example, the Fund may invest in master demand notes, a type of commercial paper
that is redeemable on demand, but for which there is no secondary market.
Furthermore, the Fund may enter into repurchase agreements with domestic banks
and broker-dealers. The payment of interest accrued by the Fund under its
repurchase agreements is dependent on the ability of the seller to perform its
obligations to the Fund. If the seller of a repurchase agreement refused to
repurchase the securities underlying the agreement, the Fund would suffer a loss
if the proceeds from the sale of the underlying securities were less than the
agreed upon repurchase price, and the loss would be increased by any cost of
selling the securities. If the defaulting seller filed for bankruptcy or became
insolvent, sale of the securities might be delayed by pending court action. In
such a case, it is not clear that the Fund would have the right, against other
claimants, to keep the securities.
For further information about the types of investments and investment
techniques available to the Fund, including the risks associated with such
investments and investment techniques, see the section of this prospectus
entitled "Additional Investment Information" and the statement of additional
information.
FUNDAMENTAL NATURE OF INVESTMENT OBJECTIVE
The investment objective of the Fund set forth above is fundamental and may
not be changed without the vote of a majority of the Fund's outstanding shares
(which means the lesser of (1) 67% of the shares represented at a meeting at
which more than 50% of the outstanding shares are represented or (2) more than
50% of the outstanding shares). Of course, there can be no assurance that the
Fund will achieve its investment objective since there is uncertainty in every
investment.
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INVESTMENT RESTRICTIONS
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The Fund has adopted the fundamental restrictions set forth below, which may
not be changed without the approval of a majority of the Fund's outstanding
shares. These restrictions and certain other fundamental restrictions are set
forth in the statement of additional information.
The Fund may not do the following: (1) invest more than 5% of its total
assets in the securities of any one issuer; (2) borrow money, except that the
Fund may borrow money from banks for emergency or extraordinary purposes in
aggregate amounts up to one-third (normally less than 5%) of its net assets and
enter into reverse repurchase agreements; (3) pledge more than 15% of its total
assets to secure borrowings; (4) invest more than 25% of its total assets in
securities of issuers in the same industry; and (5) invest more than 10% of its
total assets in repurchase agreements maturing in more than seven days.
In addition, the Fund may, notwithstanding any other investment policy or
restriction, invest all of its assets in the securities of a single open-end
management investment company with substantially the same fundamental investment
objectives, policies and restrictions as the Fund. The Fund does not currently
intend to implement this policy and would do so only if the Trustees were to
determine such action to be in the best interest of the Fund and its
shareholders. In the event of such implementation, the Fund will comply with
such requirements as to written notice to shareholders as are then in effect.
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RISK FACTORS
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The risk inherent in investing in the Fund is that risk common to any
security, that the net asset value will fluctuate in response to changes in
economic conditions, interest rates and the market's perception of the
underlying portfolio securities of the Fund.
The Fund is not intended to constitute a balanced investment program and is
not designed for investors seeking capital appreciation or maximum tax-exempt
income irrespective of fluctuations in principal or marketability. Shares of the
Fund would not be suitable for tax-exempt institutions and may not be suitable
for certain retirement plans which are unable to benefit from the Fund's
tax-exempt dividends. In addition, the Fund may not be an appropriate investment
for entities which are "substantial users" of facilities financed by industrial
development bonds or related persons thereof.
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PRICING SHARES
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The net asset value of a Fund share is computed each day on which the New
York Stock Exchange (the "Exchange") is open as of the close of trading on the
Exchange (currently 4:00 p.m. Eastern time for the purpose of pricing Fund
shares) except on days when changes in the value of the Fund's securities do not
affect the current net asset value of its shares. The Exchange currently is
closed on weekends, New Year's Day, Presidents' Day, Good Friday, Memorial Day,
Independence Day, Labor Day, Thanksgiving Day and Christmas Day. The net asset
value per share is arrived at by determining the value of all of the Fund's
assets, subtracting all liabilities and dividing the result by the number of
shares outstanding.
The Fund values municipal bonds on the basis of valuations provided by a
pricing service, approved by the Fund's Board of Trustees, which uses
information with respect to transactions in bonds, quotations from bond dealers,
market transactions in comparable securities and various relationships between
securities in determining value. The Fund values short-term instruments with
maturities of sixty days or less at amortized cost (original purchase cost as
adjusted for amortization of premium or accretion of discount), which, when
combined with accrued interest, approximates market. Short-term instruments
maturing in more than sixty days for which market quotations are readily
available are valued at current market value. Short-term instruments maturing
in more than sixty days when purchased which are held on the sixtieth day prior
to maturity are valued at amortized cost (market value on the sixtieth day
adjusted for amortization of premium or accretion of discount), which, when
combined with accrued interest, approximates market and which in any case
reflects fair value as determined by the Fund's Board of Trustees. All other
investments are valued at market value or, where market quotations are not
readily available, at fair value as determined in good faith using methods
prescribed by the Fund's Board of Trustees.
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DIVIDENDS AND TAXES
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The Fund has qualified and intends to qualify in the future as a regulated
investment company under the Code. The Fund qualifies if, among other things, it
distributes to its shareholders at least 90% of its net investment income for
its fiscal year. The Fund also intends to make timely distributions, if
necessary, sufficient in amount to avoid the nondeductible 4% excise tax imposed
on a regulated investment company to the extent that it fails to distribute,
with respect to each calendar year, at least 98% of its ordinary income for such
calendar year and 98% of its net capital gains for the one-year period ending on
October 31 of such calendar year. Any such distributions would be (1) declared
on or before December 31 to shareholders of record in December, (2) paid by the
following January 31, and (3) includable in the taxable income of shareholders
for the year in which such distributions were declared. If the Fund qualifies
and if it distributes all of its net investment income and net capital gains, if
any, to shareholders, it will be relieved of any federal income tax liability.
Commissions paid by the Fund on new sales of shares under the Fund's
Distribution Plan (see Distribution Plan) and deferred sales charge receipts are
treated as capital charges and capital credits, respectively, in determining net
investment income for tax purposes. For financial statement purposes, these
expenses and receipts are treated as operating expenses and revenues. As a
result, the amount of dividend distributions required to satisfy the
requirements of the Code might exceed net investment income for financial
statement purposes, resulting in a portion of such dividends being a
distribution in excess of net investment income for financial statement
purposes, but not for tax purposes. Total investment return has been unaffected
by both treatments.
The Fund intends to declare dividends from net investment income daily and
distribute to its shareholders such dividends monthly and to declare and
distribute all net realized long-term capital gains annually. All dividends and
distributions will be payable in shares or, at the option of the shareholder, in
cash. All shareholders may receive dividends in shares without being subject to
a deferred sales charge when such shares are redeemed. Shareholders who have not
opted prior to the record date for any distribution to receive cash will have
the number of such shares determined on the basis of the Fund's net asset value
per share computed at the end of the day on the record date after adjustment for
the distribution. Net asset value is used in computing the number of shares in
both capital gains and income distribution reinvestments. There is a possibility
that shareholders may lose the tax-exempt status on accrued income on municipal
bonds if shares of the Fund are redeemed before a dividend has been declared.
Account statements and/or checks as appropriate will be mailed to shareholders
within seven days after the Fund pays the distribution. Unless the Fund receives
instructions to the contrary from a shareholder before the record date, it will
assume that the shareholder wishes to receive that distribution and future
capital gains and income distributions in shares. Instructions continue in
effect until changed in writing.
Under normal circumstances, the Fund expects that substantially all of its
dividends will be "exempt interest dividends," which will be treated by its
shareholders as excludable from federal gross income. In order to pay exempt
interest dividends, at the close of each quarter at least 50% of the value of
the Fund's assets must consist of federally tax-exempt obligations. An exempt
interest dividend is any dividend or part thereof (other than a capital gain
dividend) paid by the Fund with respect to its net federally excludable
municipal bond interest and designated as an exempt interest dividend in a
written notice mailed to shareholders not later than sixty days after the close
of its taxable year. The percentage of the total dividends paid by the Fund with
respect to any taxable year which qualifies as exempt interest dividends will be
the same for all shareholders receiving dividends with respect to such year. If
a shareholder receives an exempt interest dividend with respect to any share and
such share is held for six months or less, any loss on the sale or exchange of
such share will be disallowed to the extent of the exempt interest dividend
amount.
Any shareholder who may be a "substantial user" of a facility financed with
an issue of tax-exempt obligations or a "related person" to such a user should
consult his tax adviser concerning his qualification to receive exempt interest
dividends should the Fund hold obligations financing such facility.
Under the Tax Reform Act of 1986, interest on certain "private activity
bonds" issued after August 7, 1986, although otherwise tax-exempt, is treated as
a tax preference item for alternative minimum tax purposes. Under regulations to
be promulgated, the Fund's exempt interest dividends will be treated the same
way to the extent attributable to interest paid on such private activity bonds.
Corporate shareholders should also be aware that the receipt of exempt interest
dividends could subject them to alternative minimum tax under the provisions of
Section 56(f) of the Code (relating generally to book income in excess of
taxable income).
Some or all of the Fund's exempt interest dividends may be subject to state
income taxes. The Fund will report to shareholders on a state by state basis the
sources of its exempt interest dividends.
Since none of the Fund's income will consist of corporate dividends, no
distributions will qualify for the 70% corporate dividends received deduction.
The Fund intends to distribute its net capital gains as capital gain
dividends; such dividends are treated by shareholders as long-term capital
gains. Such distributions will be designated as capital gain dividends by a
written notice mailed to each shareholder no later than sixty days after the
close of the Fund's taxable year. If a shareholder receives a capital gain
dividend and holds his shares for six months or less, then any allowable loss on
disposition of such shares will be treated as a long-term capital loss to the
extent of such capital gain dividend.
Interest on indebtedness incurred or continued by shareholders to purchase
or carry shares of the Fund will not be deductible for federal income tax
purposes to the extent of the portion of the interest expense relating to exempt
interest dividends; that portion is determined by multiplying the total amount
of interest paid or accrued on the indebtedness by a fraction, the numerator of
which is the exempt interest dividends received by a shareholder in his taxable
year and the denominator of which is the sum of the exempt interest dividends
and the taxable distributions out of the Fund's investment income and short-term
capital gains received by the shareholder.
The foregoing is only a summary of some of the important tax considerations
generally affecting the Fund and its shareholders. No attempt is made to present
a detailed explanation of the federal income tax treatment of the Fund or its
shareholders, and this discussion is not intended as a substitute for careful
tax planning. Accordingly, potential investors in the Fund are urged to consult
their tax advisers with specific reference to their own tax situation.
As mentioned above, at the end of each quarter at least 50% of the value of
the Fund's assets must be invested in tax-exempt obligations in order for
distributions to qualify as exempt interest dividends. Under particularly
unusual circumstances, such as when the Fund is in a prolonged defensive
investment position, it is possible that no portion of the Fund's distributions
of income to its shareholders for a fiscal year would be exempt from federal
income tax; however, the Fund does not presently anticipate that such unusual
circumstances will occur.
For the fiscal year ended December 31, 1993, approximately 100% of the
Fund's income distributions were designated as exempt from federal income taxes.
The Fund advises its shareholders annually as to the federal tax status of all
distributions made during the year.
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FUND MANAGEMENT AND EXPENSES
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FUND MANAGEMENT
Subject to the general supervision of the Fund's Board of Trustees, Keystone
Management, located at Nevada Financial Center, 3800 Howard Hughes Parkway, Las
Vegas, Nevada 89109, serves as invest ment manager to the Fund and is
responsible for the overall management of the Fund's business and affairs.
Keystone Management, organized in 1989, is a wholly-owned subsidiary of
Keystone, and its directors and principal executive officers have been
affiliated with Keystone, a seasoned investment adviser, for a number of years.
Keystone Management also serves as investment manager to to each of the other
Keystone Custodian Funds and to certain other funds in the Keystone Group of
Mutual Funds.
The Fund pays Keystone Management at the end of each calendar month a fee
for its services consisting of (1) an amount calculated as set forth below:
Annual Aggregate Net Asset Value
Management of the Shares
Fee Income of the Fund
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2.0% of
Gross Dividend and
Interest Income
Plus
0.50% of the first $100,000,000, plus
0.45% of the next $100,000,000, plus
0.40% of the next $100,000,000, plus
0.35% of the next $100,000,000, plus
0.30% of the next $100,000,000, plus
0.25% of amounts over $500,000,000;
and (2) an amount equal to the amount of reimbursable expenses of Keystone
Management accrued during such calendar month.
Pursuant to its Investment Management Agreement with the Fund (the
"Management Agreement"), Keystone Management has delegated its investment
management functions, except for certain administrative and management services
to be performed in Nevada, to Keystone and has entered into an Investment
Advisory Agreement with Keystone (the "Investment Advisory Agreement"), under
which Keystone provides investment advisory and management services to the Fund.
Services performed at the office maintained in Nevada by Keystone Management
include (1) performing research and planning with respect to (a) the Fund's
qualification as a regulated investment company under Subchapter M of the Code,
(b) tax treatment of the Fund's portfolio investments, (c) tax treatment of
special corporate actions (such as reorganizations), (d) state tax matters
affecting the Fund, and (e) the Fund's distributions of income and capital
gains; (2) preparing the Fund's federal and state tax returns; (3) providing
services to the Fund's shareholders in connection with federal and state
taxation and distributions of income and capital gains; and (4) storing
documents relating to the Fund's activities.
Keystone, located at 200 Berkeley Street, Boston, Massachusetts 02116-5034,
has provided investment advisory and management services to investment companies
and private accounts since it was organized in 1932. Keystone is a wholly-owned
subsidiary of Keystone Group, Inc. ("Keystone Group"), 200 Berkeley Street,
Boston, Massachusetts 02116-5034.
Keystone Group is a corporation privately owned by members of management of
Keystone and its affiliates. The shares of Keystone Group common stock
beneficially owned by management are held in a number of voting trusts, the
trustees of which are George S. Bissell, Albert H. Elfner, III, Roger T.
Wickers, Edward F. Godfrey and Ralph J. Spuehler, Jr. Keystone Group provides
accounting, bookkeeping, legal, personnel and general corporate services to
Keystone Management, Keystone, their affiliates and the Keystone Group of Mutual
Funds.
Pursuant to the Investment Advisory Agreement, Keystone receives for its
services an annual fee representing 85% of the management fee received by
Keystone Management under the Investment Management Agreement.
For the fiscal year ended December 31, 1993, the Fund paid or accrued to
Keystone Management investment management fees of $6,507,055, which represented
0.43% of the Fund's average net assets. Of such amount paid to Keystone
Management, $5,530,997 was paid to Keystone for its services to the Fund. In
addition, the Fund reimbursed Keystone Management $2,488,890, which represented
0.16% of the Fund's average net assets, in connection with reimbursable expenses
paid by Keystone Management on behalf of the Fund under the Investment
Management Agreement. For the fiscal year ended December 31, 1993, the total fee
paid to Keystone Management by the Fund for investment management and
administrative services fees was $8,995,945, which represented 0.59% of the
Fund's average net assets.
FUND EXPENSES
In addition to the investment advisory and management fees discussed above,
the principal expenses that the Fund is expected to pay include, but are not
limited to, expenses of its transfer agent, its custodian and its independent
auditors, expenses under its Distribution Plan, fees of its Independent Trustees
("Independent Trustees"), expenses of shareholders' and Trustees' meetings, fees
payable to government agencies, including registration and qualification fees of
the Fund and its shares under federal and state securities laws, expenses of
preparing, printing and mailing Fund prospectuses, notices, reports and proxy
material and certain extraordinary expenses. In addition to such expenses, the
Fund pays its brokerage commissions, interest charges and taxes. For the fiscal
year ended December 31, 1993, the Fund paid 1.66% of its average net assets in
expenses.
The Fund is subject to certain state annual expense limitations, the most
restrictive of which is as follows:
2.5% of the first $30 million of Fund average net assets;
2.0% of the next $70 million of Fund average net assets; and
1.5% of Fund average net assets over $100 million.
Capital charges and certain expenses, including a portion of the Fund's
Distribution Plan expenses, are not included in the calculation of the state
expense limitations. This limitation may be modified or eliminated in the
future.
During the fiscal year ended December 31, 1993, the Fund paid or accrued to
Keystone Investor Resource Center, Inc. ("KIRC"), the Fund's transfer and
dividend disbursing agent, $29,735 for certain accounting and printing services
and $1,657,577 for shareholder services. KIRC is a wholly-owned subsidiary of
Keystone. The amount for shareholder services is included in the amount of
reimbursable expenses paid on behalf of the Fund by Keystone Management.
PORTFOLIO MANAGER
Betsy A. Blacher has been the Fund's Portfolio Manager since 1991. She is a
Keystone Vice President and Senior Portfolio Manager and has more than 15 years
of investment experience.
SECURITIES TRANSACTIONS
Keystone selects broker-dealers to execute transactions subject to the
receipt of best execution. When selecting broker-dealers to execute portfolio
transactions for the Fund, Keystone may follow a policy of considering as a
factor the number of shares of the Fund sold by such broker-dealers. In
addition, broker-dealers may from time to time be affiliated with the Fund,
Keystone Management, Keystone, the Fund's principal underwriter or their
affiliates.
PORTFOLIO TURNOVER
The Fund's portfolio turnover rates for the fiscal years ended December 31,
1993 and 1992 were 76% and 78%, respectively.
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HOW TO BUY SHARES
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The Fund offers its shares by direct investment only to shareholders who
beneficially owned shares of the Fund on December 31, 1990. The Fund also offers
its shares through exchanges to shareholders of certain other Keystone Group
Funds.
Shares of the Fund may be purchased from any broker-dealer that has a
selling agreement with Keystone Distributors, Inc. ("KDI"), the Fund's principal
underwriter ("Principal Underwriter"). KDI, a wholly-owned subsidiary of
Keystone, is located at 200 Berkeley Street, Boston, Massachusetts 02116-5034.
Shares become entitled to income distributions declared on the first
business day following receipt by the Fund's transfer agent of payment for the
shares. It is the investor's responsibility to see that his dealer promptly
forwards payment to KDI for shares being purchased through the dealer.
Orders for shares received by broker-dealers prior to that day's close of
trading on the Exchange and transmitted to the Fund prior to its close of
business that day will receive the offering price equal to the net asset value
per share computed at the close of trading on the Exchange on the same day.
Orders received by broker-dealers after that day's close of trading on the
Exchange and transmitted to the Fund prior to the close of business on the next
business day will receive the next business day's offering price. The initial
purchase must be at least $10,000. Purchase payments are fully invested at net
asset value. There are no sales charges on purchases of Fund shares at the time
of purchase.
CONTINGENT DEFERRED SALES CHARGE
With certain exceptions, when shares are redeemed within four calendar years
after their purchase, a contingent deferred sales charge may be imposed at rates
ranging from a maximum of 4% of amounts redeemed during the calendar year of
purchase to 1% of amounts redeemed during the third calendar year after the year
of purchase. No contingent deferred sales charge is imposed on amounts redeemed
thereafter or on shares purchased through reinvestment of dividends and
distributions. If imposed, the contingent deferred sales charge is deducted from
the redemption proceeds otherwise payable to the shareholder. Since July 8,
1992, the contingent deferred sales charge attributable to shares purchased
prior to January 1, 1992 has been retained by the Fund, and the contingent
deferred sales charge attributable to shares purchased after January 1, 1992 is,
to the extent permitted by a new rule adopted by the NASD, paid to KDI.
Accordingly, for the fiscal year ended December 31, 1993, the Fund retained
$373,564 and KDI received $482,452, respectively, in deferred sales charges.
The contingent deferred sales charge is a declining percentage of the lesser
of (1) the net asset value of the shares redeemed or (2) the total cost of such
shares. No contingent deferred sales charge is imposed when a shareholder
redeems amounts derived from (1) increases in the value of his account above the
total cost of such shares due to increases in the net asset value per share of
the Fund; (2) certain shares with respect to which the Fund did not pay a
commission on issuance, including shares acquired through reinvestment of
dividend income and capital gains distributions; or (3) shares held in all or
part of more than four consecutive calendar years.
In determining whether a contingent deferred sales charge is payable and, if
so, the percentage charge applicable, it is assumed that shares held the longest
are the first to be redeemed. There is no deferred sales charge imposed on
exchanges of shares between Keystone funds that have adopted distribution plans
pursuant to Rule 12b-1 under the 1940 Act. Moreover, when shares of one such
fund have been exchanged for shares of another such fund, for purposes of any
future contingent deferred sales charge, the calendar year of the purchase of
the shares of the Fund exchanged into is assumed to be the year shares tendered
for exchange were originally purchased.
WAIVER OF DEFERRED SALES CHARGE
Shares also may be sold, to the extent permitted by applicable law, at net
asset value without the payment of commissions or the imposition of a deferred
sales charge upon redemption of Fund shares to (1) certain officers, Directors,
Trustees and employees of the Fund, Keystone Management, Keystone and certain of
their affiliates; (2) registered representatives of firms with dealer agreements
with KDI; and (3) a bank or trust company acting as trustee for a single
account.
In addition, no contingent deferred sales charge is imposed on a redemption
of shares of the Fund in the event of (1) death or disability of the
shareholder; (2) involuntary redemptions of accounts having an aggregate net
asset value of less than $1,000; or (3) automatic withdrawals under an automatic
withdrawal plan of up to 1 1/2% per month of the shareholder's initial account
balance.
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DISTRIBUTION PLAN
- ------------------------------------------------------------------------------
The Fund bears some of the costs of selling its shares under a Distribution
Plan adopted on June 1, 1983 pursuant to Rule 12b-1 under the 1940 Act. The
Fund's Distribution Plan provides that the Fund may expend up to 0.3125%
quarterly (approximately 1.25% annually) of average daily net asset value of its
shares to pay distribution costs for sales of its shares and to pay shareholder
service fees. A rule adopted by the NASD, effective July 7, 1993, limits such
annual expenditures to 1%, of which 0.75% may be used to pay such distribution
costs and 0.25% may be used to pay shareholder service fees. The aggregate
amount that the Fund may pay for such distribution costs is limited to 6.25% of
gross share sales since the inception of the Fund's Distribution Plan plus
interest at the prime rate plus 1% on unpaid amounts thereof (less any
contingent deferred sales charges paid by shareholders to KDI).
Amounts paid under the Distribution Plan are paid to the Fund's Principal
Underwriter, currently KDI, (1) as commissions for Fund shares sold under the
Distribution Plan, all or any part of which commissions may be reallowed by KDI
to others for selling the Fund shares, and (2) to enable KDI to pay such others
shareholder service fees in respect of shares sold by them after inception of
the Distribution Plan and remaining outstanding on the Fund's books for
specified periods. Amounts paid or accrued to KDI under (1) and (2) in the
aggregate may not exceed the annual limitation referred to above. From the
amounts received by KDI in connection with the Distribution Plan, and subject to
the limitations discussed above, KDI generally pays brokers or others a
commission equal to 3% of the price paid to the Fund for each sale of Fund
shares as well as a shareholder service fee at a rate of 0.25% per annum of the
net asset value of shares sold by such brokers or others and remaining
outstanding on the books of the Fund for specified periods.
If the Fund is unable to pay KDI a commission on a new sale because the
annual maximum (0.75% of average daily net assets) has been reached, KDI
intends, but is not obligated, to continue to accept new orders for the purchase
of Fund shares and to pay or accrue commissions and service fees to dealers in
excess of the amount it currently receives from the Fund. While the Fund is
under no contractual obligation to pay KDI such amounts which exceed the
Distribution Plan limitation, KDI intends to seek full payment of such charges
from the Fund (together with interest at the rate of prime plus one percent) at
such time in the future as, and to the extent that, payment thereof by the Fund
would be within permitted limits. KDI currently intends to seek payment of
interest only on such charges paid or accrued by KDI subsequent to January 1,
1992. If the Fund's Independent Trustees authorize such payments, the effect
would be to extend the period of time during which the Fund incurs the maximum
amount of costs allowed by the Distribution Plan. If the Distribution Plan is
terminated, KDI will ask the Independent Trustees to take whatever action they
deem appropriate under the circumstances with respect to payment of such
amounts. If under changing conditions KDI were to seek payment of interest on
such amounts, any such interest payments also would have to be approved by the
Independent Trustees (and possibly the shareholders).
During the fiscal year ended December 31, 1993, the Fund recovered $373,564
in deferred sales charges. During the year, the Fund paid KDI $16,608,165 (1.09%
of the Fund's average daily net asset value during the year) under the
Distribution Plan, of which $4,272,087 represented repayments of amounts paid by
KDI during the year or in previous years in excess of amounts received by KDI
under the Distribution Plan. The amount paid by the Fund under its Distribution
Plan, net of deferred sales charges, was $16,234,601 (1.06% of the Fund's
average daily net asset value during the year). During the year, KDI retained
$9,241,496 and paid commissions on new sales and service fees to dealers and
others of $7,366,669. In addition, during the year KDI received $482,452 in
deferred sales charges, reducing total advances outstanding to $8,498,955 (0.55%
of the Fund's net asset value as of December 31, 1993).
The amounts and purposes of expenditures under the Distribution Plan must be
reported to the Independent Trustees quarterly. The Independent Trustees may
require or approve changes in the operation of the Distribution Plan and may
require that total expenditures by the Fund under the Distribution Plan be kept
within limits lower than the maximum amount permitted by the Distribution Plan
as stated above. If such costs are not limited by the Independent Trustees, such
costs could, for some period of time, be higher than such costs permitted by
most other plans presently adopted by other investment companies.
The Distribution Plan may be terminated at any time by vote of the Fund's
Independent Trustees or by vote of a majority of the outstanding voting shares
of the Fund. Any change in the Distribution Plan that would materially increase
the distribution expenses of the Fund provided for in the Distribution Plan
requires shareholder approval. Otherwise, the Distribution Plan may be amended
by votes of the majority of both (1) the Fund's Trustees and (2) the Independent
Trustees, cast in person at a meeting called for the purpose of voting on such
amendment.
While the Distribution Plan is in effect, the Fund is required to commit the
selection and nomination of candidates for Independent Trustees to the
discretion of the Independent Trustees.
Whether any expenditure under the Distribution Plan is subject to a state
expense limit depends upon the nature of the expenditure and the terms of the
state law, regulation or order imposing the limit. A portion of the Fund's
Distribution Plan expenses may be includable in the Fund's total operating
expenses for purposes of determining compliance with state expense limits.
Upon written notice to dealers, KDI, at its own expense may periodically
sponsor programs which offer additional compensation in connection with sales of
Fund shares. Participation in such programs may be available to all dealers or
to selected dealers who have sold or are expected to sell significant amounts of
shares. Additional compensation may also include financial assistance to dealers
in connection with preapproved seminars, conferences and advertising. No such
programs or additional compensation will be offered to the extent they are
prohibited by the laws of any state or any self-regulatory agency, such as the
NASD.
The Glass-Steagall Act currently limits the ability of a depository
institution (such as a commercial bank or a savings and loan association) to
become an underwriter or distributor of securities. In the event the Glass-
Steagall Act is deemed to prohibit depository institutions from accepting
payments under the arrangement described above, or should Congress relax current
restrictions on depository institutions, the Board of Trustees will consider
what action, if any, is appropriate.
In addition, state securities laws on this issue may differ from the
interpretations of federal law expressed herein and banks and financial
institutions may be required to register as dealers pursuant to state law.
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HOW TO REDEEM SHARES
- ------------------------------------------------------------------------------
Fund shares may be redeemed for cash at the redemption value upon written
order by the shareholder(s) to the Fund, c/o Keystone Investor Resource Center,
Inc., Box 2121, Boston, Massachusetts 02106-2121, and presentation to the Fund
of a properly endorsed share certificate if certificates have been issued. The
signature(s) of the shareholder(s) on the written order and certificates must be
guaranteed. The redemption value is the net asset value adjusted for fractions
of a cent and may be more or less than the shareholder's cost depending upon
changes in the value of the Fund's portfolio securities between purchase and
redemption. A deferred sales charge may be imposed by the Fund at the time of
redemption of certain shares as explained in "How to Buy Shares." If imposed,
the deferred sales charge is deducted from the redemption proceeds otherwise
payable to the shareholder.
At various times the Fund may be requested to redeem shares for which it has
not yet received good payment. In such a case the Fund may delay the mailing of
a redemption check or the wiring of redemption proceeds until good payment has
been collected for the purchase of such shares. This may take up to 15 days or
more. Any delay may be avoided by purchasing shares with a certified check drawn
on a U.S. bank or by bank wire of funds. Although the mailing of a redemption
check or the wiring of redemption proceeds may be delayed, the redemption value
will be determined and the redemption processed in the ordinary course of
business upon receipt of proper documentation. In such a case, after redemption
and prior to the release of the proceeds, no appreciation or depreciation will
occur in the value of the redeemed shares, and no interest will be paid on the
redemption proceeds. If the mailing of a redemption has been delayed, the check
will be mailed or the proceeds wired promptly after good payment has been
collected.
The Fund computes the redemption value at the close of the Exchange at the
end of the day on which it has received all proper documentation from the
shareholder. Payment of the amount due on redemption, less any applicable
deferred sales charge, will be made within seven days thereafter.
Shareholders also may redeem their shares through their broker-dealers. KDI,
acting as agent for the Fund, stands ready to repurchase Fund shares upon orders
from dealers as follows: redemption requests received by broker-dealers prior to
that day's close of trading on the Exchange and transmitted to the Fund prior to
its close of business that day will receive the net asset value per share
computed at the close of trading on the Exchange on the same day. Redemption
requests received by broker-dealers after that day's close of trading on the
Exchange and transmitted to the Fund prior to the close of business on the next
business day will receive the next business day's net asset value price. KDI
will pay the redemption proceeds, less any applicable deferred sales charge, to
the dealer placing the order within seven days thereafter, assuming it has
received proper documentation. KDI charges no fees for this service, but the
shareholder's broker-dealer may do so.
For the protection of shareholders, SIGNATURES ON CERTIFICATES, STOCK POWERS
AND ALL WRITTEN ORDERS OR AUTHORIZATIONS MUST BE GUARANTEED BY A U.S. STOCK
EXCHANGE MEMBER, A U.S. COMMERCIAL BANK OR TRUST COMPANY OR OTHER PERSONS
ELIGIBLE TO GUARANTEE SIGNATURES UNDER THE SECURITIES EXCHANGE ACT OF 1934 AND
KIRC'S POLICIES. The Fund and KIRC may waive this requirement but may also
require additional documents in certain cases. Currently, the requirement for a
signature guarantee has been waived on redemptions of $50,000 or less where the
account address of record has been the same for a minimum period of 30 days. The
Fund and KIRC reserve the right to withdraw this waiver at any time.
If the Fund receives a redemption or repurchase order but the shareholder
has not clearly indicated the amount of money or number of shares involved, the
Fund cannot execute the order. In such cases, the Fund will request the missing
information from the shareholder and process the order the day it receives such
information.
TELEPHONE
Under ordinary circumstances, you may redeem up to $50,000 from your account
by telephone by calling toll free 1-800-343-2898. To engage in telephone
transactions generally, you must complete the appropriate sections of the Fund's
application.
In order to insure that instructions received by KIRC are genuine when you
initiate a telephone transaction, you will be asked to verify certain criteria
specific to your account. At the conclusion of the transaction, you will be
given a transaction number confirming your request, and written confirmation of
your transaction will be mailed the next business day. Your telephone
instructions will be recorded. Redemptions by telephone are allowed only if the
address and bank account of record have been the same for a minimum period of 30
days. If you cannot reach the Fund by telephone, you should follow the
procedures for redeeming by mail or through a broker as set forth above.
GENERAL
The Fund reserves the right, at any time, to terminate, suspend or change
the terms of any redemption method described in this prospectus, except
redemption by mail, and to impose fees.
Except as otherwise noted, neither the Fund, KIRC nor KDI assumes
responsibility for the authenticity of any instructions received by any of them
from a shareholder in writing, over the Keystone Automated Response Line
("KARL") or by telephone. KIRC will employ reasonable procedures to confirm that
instructions received over KARL or by telephone are genuine. Neither the Fund,
KIRC nor KDI will be liable when following instructions received over KARL or by
telephone that KIRC reasonably believes to be genuine. If, for any reason,
reasonable procedures are not followed, the Fund, KIRC, or KDI may be liable for
any losses due to unauthorized or fraudulent instructions.
The Fund may temporarily suspend the right to redeem its shares when (1) the
Exchange is closed, other than customary weekend and holiday closings; (2)
trading on the Exchange is restricted; (3) an emergency exists and the Fund
cannot dispose of its investments or fairly determine their value; or (4) the
Securities and Exchange Commission so orders.
SMALL ACCOUNTS
Because of the high cost of maintaining small accounts, the Fund reserves
the right to redeem your account if its value has fallen below $1,000, the
current minimum investment level, as a result of your redemptions (but not as a
result of market action). You will be notified in writing and allowed 60 days to
increase the value of your account to the minimum investment level. No deferred
sales charges are applied to such redemptions.
REDEMPTIONS IN KIND
If conditions arise that would make it undesirable for the Fund to pay for
all redemptions in cash, the Fund may authorize payment to be made in portfolio
securities or other property. However, the Fund has obligated itself under the
1940 Act to redeem for cash all shares of the Fund presented for redemption by
any one shareholder up to the lesser of $250,000 or 1% of the Fund's net assets
in any 90-day period. Securities delivered in payment of redemptions would be
valued at the same value assigned to them in computing the net asset value per
share and would, to the extent permitted by law, be readily marketable.
Shareholders receiving such securities would incur brokerage costs when these
securities are sold.
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SHAREHOLDER SERVICES
- ------------------------------------------------------------------------------
Details on all shareholder services may be obtained from KIRC, by writing or
by calling toll free 1-800-343-2898.
KEYSTONE AUTOMATED RESPONSE LINE
KARL offers you specific fund account information and price and yield
quotations as well as the ability to effect account transactions, including
investments, exchanges and redemptions. You may access KARL by dialing toll-
free 1-800-346-3858 on any touch-tone telephone, 24 hours a day, seven days a
week.
EXCHANGES
A shareholder who has obtained the appropriate prospectus may exchange
shares of the Fund for shares of any of the eight Keystone Custodian Funds,
Keystone Precious Metals Holdings, Inc., ("KPMH"), Keystone International Fund
Inc. ("KIF"), Keystone Tax Exempt Trust ("KTET") or Keystone Liquid Trust
("KLT") on the basis of their respective net asset values by calling toll free
1-800-343-2898 or by writing KIRC at Box 2121, Boston, Massachusetts 02106-
2121. (See "How to Redeem Shares" for additional information on telephone
transactions.)
Fund Shares purchased by check may be exchanged for shares of the named
funds, other than KPMH or KTET, after 15 days. In order to exchange Fund shares
for shares of KPMH or KTET, a shareholder must have held Fund shares for a
period of at least six months. There is a $10.00 exchange fee for each exchange.
There is no fee for exchange orders received by the Fund over KARL. If the
shares being tendered for exchange have been held for less than four years and
are still subject to a deferred sales charge, such charge will carry over to the
shares being acquired in the exchange transaction. The Fund reserves the right,
after providing the required notice to shareholders, to terminate this exchange
offer or to change its terms, including the right to change the fee for any
exchange.
Orders to exchange shares of the Fund for shares of KLT will be executed by
redeeming the shares of the Fund and purchasing shares of KLT at the net asset
value of KLT shares determined after the proceeds from such redemption become
available, which may be up to seven days after such redemption. In all other
cases, orders for exchanges received by the Fund prior to 4:00 p.m. on any day
the funds are open for business will be executed at the respective net asset
values determined as of the close of business that day. Orders for exchanges
received after 4:00 p.m. on any business day will be executed at the respective
net asset values determined at the close of the next business day.
An excessive number of exchanges may be disadvantageous to the Fund.
Therefore, the Fund, in addition to its right to reject any exchange, reserves
the right to terminate the exchange privilege of any shareholder who makes more
than five exchanges of shares of the funds in a year or three in a calendar
quarter.
An exchange order must comply with the requirements for a redemption or
repurchase order and must specify the dollar value or number of shares to be
exchanged. Exchanges are subject to the minimum initial purchase requirements of
the fund being acquired. An exchange constitutes a sale for federal income tax
purposes.
The exchange privilege is available only in states where shares of the fund
being acquired may legally be sold.
AUTOMATIC WITHDRAWAL PLAN
Under an Automatic Withdrawal Plan, shareholders may arrange for regular
monthly or quarterly fixed withdrawal payments. Each payment must be at least
$100 and may be as much as 1% per month or 3% per quarter of the total net asset
value of the Fund shares in the shareholder's account when the Automatic
Withdrawal Plan is opened. Fixed withdrawal payments are not subject to a
deferred sales charge. Excessive withdrawals may decrease or deplete the value
of a shareholder's account.
OTHER SERVICES
Under certain circumstances shareholders may, within 30 days after a
redemption, reinstate their accounts at current net asset value.
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PERFORMANCE DATA
- ------------------------------------------------------------------------------
From time to time, the Fund may advertise "total return," "current yield"
and "tax equivalent yield." ALL FIGURES ARE BASED ON HISTORICAL EARNINGS AND ARE
NOT INTENDED TO INDICATE FUTURE PERFORMANCE. Total return refers to the Fund's
average annual compounded rates of return over specified periods determined by
comparing the initial amount invested to the ending redeemable value of that
amount. The resulting equation assumes reinvestment of all dividends and
distributions and deduction of all recurring charges applicable to all
shareholder accounts. The deduction of the contingent deferred sales charge is
reflected in the applicable years. The exchange fee is not included in the
calculation.
Current yield quotations represent the yield on an investment for a stated
30-day period computed by dividing net investment income earned per share during
the base period by the maximum offering price per share on the last day of the
base period.
Tax equivalent yield is, in general, the current yield divided by a factor
equal to one minus a stated income tax rate and reflects the yield a taxable
investment would have to achieve in order to equal on an after-tax basis a tax
exempt yield.
The Fund may also include comparative performance and general mutual fund
industry information in advertising or marketing the Fund's shares, such as data
from Lipper Analytical Services, Inc. or other financial and industry
publications.
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FUND SHARES
- ------------------------------------------------------------------------------
The Fund currently issues one class of shares which participate equally in
dividends and distributions and have equal voting, liquidation and other rights.
When issued and paid for, the shares will be fully paid and nonassessable by the
Fund. Shares may be exchanged as explained under "Shareholder Services," but
will have no other preference, conversion, exchange or preemptive rights. Shares
are redeemable, transferable and freely assignable as collateral. There are no
sinking fund provisions. The Fund may establish additional classes or series of
shares.
Shareholders of the Fund are entitled to one vote for each full share owned
and fractional votes for fractional shares. The Fund will have special meetings
from time to time as required under its Declaration of Trust and under the 1940
Act. As provided in the Fund's Declaration of Trust, shareholders have the right
to remove Trustees by an affirmative vote of two-thirds of the outstanding
shares. A special meeting of the shareholders will be held when 10% of the
outstanding shares request a meeting for the purpose of removing a Trustee. As
prescribed by Section 16(c) of the 1940 Act, shareholders may be eligible for
shareholder communication assistance in connection with the special meeting.
Under Massachusetts law it is possible that a Fund shareholder may be held
personally liable for the Fund's obligations. However, the Fund's Declaration of
Trust provides that shareholders shall not be subject to any personal liability
for the Fund's obligations and provides indemnification from Fund assets for any
shareholder held personally liable for the Fund's obligations. Disclaimers of
such liability are included in each Fund agreement.
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ADDITIONAL INFORMATION
- ------------------------------------------------------------------------------
KIRC, located at 101 Main Street, Cambridge, Massachusetts 02142-1515, is a
wholly owned subsidiary of Keystone and serves as the Fund's transfer agent and
dividend disbursing agent.
When the Fund determines from its records that more than one account in the
Fund is registered in the name of a shareholder or shareholders having the same
address, upon written notice to those shareholders the Fund intends, when an
annual report or semi-annual report of the Fund is required to be furnished, to
mail one copy of such report to that address.
Except as otherwise stated in this prospectus or required by law, the Fund
reserves the right to change the terms of the offer stated in this prospectus
without shareholder approval, including the right to impose or change fees for
services provided.
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ADDITIONAL INVESTMENT INFORMATION
- ------------------------------------------------------------------------------
DESCRIPTIONS OF CERTAIN TYPES OF INVESTMENTS
AND INVESTMENT TECHNIQUES
AVAILABLE TO THE FUND
OBLIGATIONS OF FOREIGN BRANCHES OF UNITED STATES BANKS
The obligations of foreign branches of U.S. banks may be general obligations
of the parent bank in addition to the issuing branch, or may be limited by the
terms of a specific obligation and by government regulation. Payment of interest
and principal upon these obligations also may be affected by governmental action
in the country of domicile of the branch (generally referred to as sovereign
risk). In addition, evidences of ownership of such securities may be held
outside the U.S. and the Fund may be subject to the risks associated with the
holding of such property overseas. Examples of governmental actions would be the
imposition of currency controls, interest limitations, withholding taxes,
seizure of assets or the declaration of a moratorium. Various provisions of
federal law governing domestic branches do not apply to foreign branches of
domestic banks.
OBLIGATIONS OF UNITED STATES BRANCHES OF FOREIGN BANKS
Obligations of U.S. branches of foreign banks may be general obligations of
the parent bank in addition to the issuing branch, or may be limited by the
terms of a specific obligation and by federal and state regulation as well as by
governmental action in the country in which the foreign bank has its head
office. In addition, there may be less publicly available information about a
U.S. branch of a foreign bank than about a domestic bank.
MASTER DEMAND NOTES
Master demand notes are unsecured obligations that permit the investment of
fluctuating amounts by the Fund at varying rates of interest pursuant to direct
arrangements between the Fund as lender and the issuer as borrower. Master
demand notes may permit daily fluctuations in the interest rate and daily
changes on the amounts borrowed. The Fund has the right to increase the amount
under the note at any time up to the full amount provided by the note agreement,
or to decrease the amount, and the borrower may repay up to the full amount of
the note without penalty. Notes purchased by the Fund must permit the Fund to
demand payment of principal and accrued interest at any time (on not more than
seven days notice). Notes acquired by the Fund may have maturities of more than
one year, provided that (1) the Fund is entitled to payment of principal and
accrued interest upon not more than seven days notice, and (2) the rate of
interest on such notes is adjusted automatically at periodic intervals which
normally will not exceed 31 days but may extend up to one year. The notes will
be deemed to have a maturity equal to the longer of the period remaining to the
next interest rate adjustment or the demand notice period. Because these types
of notes are direct lending arrangements between the lender and borrower, such
instruments are not normally traded and there is no secondary market for these
notes, although they are redeemable and thus repayable by the borrower at face
value plus accrued interest at any time. Accordingly, the Fund's right to redeem
is dependent on the ability of the borrower to pay principal and interest on
demand. In connection with master demand notes, Keystone considers, under
standards established by the Board of Trustees, earning power, cash flow and
other liquidity ratios of the borrower and will monitor the ability of the
borrower to pay principal and interest on demand. These notes are not typically
rated by credit rating agencies. Unless rated, the Fund may invest in them only
if at the time of an investment the issuer meets the criteria established for
commercial paper discussed in the Statement of Additional Information, which
limit such investments to commercial paper rated A-1 by S&P, Prime-1 by Moody's
and F-1 by Fitch Investors Service, Inc.
REPURCHASE AGREEMENTS
The Fund may enter into repurchase agreements with member banks of the
Federal Reserve System which have at least $1 billion in assets, primary dealers
in U.S. government securities or other financial institutions believed by
Keystone to be creditworthy. Such persons are required to be registered as U.S.
government securities dealers with an appropriate regulatory organization. Under
such agreements, the bank, primary dealer or other financial institution agrees,
upon entering into the contract, to repurchase the security at a mutually agreed
upon date and price, thereby determining the yield during the term of the
agreement. This results in a fixed rate of return insulated from market
fluctuations during such period. Under a repurchase agreement, the seller must
maintain the value of the securities subject to the agreement at not less than
the repurchase price, and such value will be determined on a daily basis by
marking the underlying securities to their market value. Although the securities
subject to the repurchase agreement might bear maturities exceeding a year, the
Fund only intends to enter into repurchase agreements which provide for
settlement within a year and usually within seven days. Securities subject to
repurchase agreements will be held by the Fund's custodian or in the Federal
Reserve book entry system. The Fund does not bear the risk of a decline in the
value of the underlying security unless the seller defaults under its repurchase
obligation. In the event of a bankruptcy or other default of a seller of a
repurchase agreement, the Fund could experience both delays in liquidating the
underlying securities and losses including (1) possible declines in the value of
the underlying securities during the period while the Fund seeks to enforce its
rights thereto; (2) possible subnormal levels of income and lack of access to
income during this period; and (3) expenses of enforcing its rights. The Board
of Trustees has established procedures to evaluate the creditworthiness of each
party with whom the Fund enters into repurchase agreements by setting guidelines
and standards of review for Keystone and monitoring Keystone's actions with
regard to repurchase agreements.
REVERSE REPURCHASE AGREEMENTS
Under a reverse repurchase agreement, the Fund would sell securities and
agree to repurchase them at a mutually agreed upon date and price. The Fund
intends to enter into reverse repurchase agreements to avoid otherwise having to
sell securities during unfavorable market conditions in order to meet
redemptions. At the time the Fund enters into a reverse repurchase agreement, it
will establish a segregated account with the Fund's custodian containing liquid
assets such as U.S. government securities or other high grade debt securities
having a value not less than the repurchase price (including accrued interest)
and subsequently will monitor the account to maintain such value. Reverse
repurchase agreements involve the risk that the market value of the securities
which the Fund is obligated to repurchase may decline below the repurchase
price. Borrowing and reverse repurchase agreements magnify the potential for
gain or loss on the portfolio securities of the Fund and, therefore, increase
the possibility of fluctuation in the Fund's net asset value. Such practices may
constitute leveraging. In the event the buyer of securities under a reverse
repurchase agreement files for bankruptcy or becomes insolvent, such buyer or
its trustee or receiver may receive an extension of time to determine whether to
enforce the Fund's obligation to repurchase the securities and the Fund's use of
the proceeds of the reverse repurchase agreement may effectively be restricted
pending such determination. The staff of the Securities and Exchange Commission
has taken the position that the 1940 Act treats reverse repurchase agreements as
being included in the percentage limit on borrowings imposed on a Fund.
"WHEN ISSUED" SECURITIES
The Fund may also purchase and sell securities and currencies on a when
issued and delayed delivery basis. When issued or delayed delivery transactions
arise when securities or currencies are purchased or sold by the Fund with
payment and delivery taking place in the future in order to secure what is
considered to be an advantageous price and yield to the Fund at the time of
entering into the transaction. When the Fund engages in when issued and delayed
delivery transactions, the Fund relies on the buyer or seller, as the case may
be, to consummate the sale. Failure to do so may result in the Fund missing the
opportunity to obtain a price or yield considered to be advantageous. When
issued and delayed delivery transactions may be expected to occur a month or
more before delivery is due. However, no payment or delivery is made by the Fund
until it receives payment or delivery from the other party to the transaction. A
separate account of liquid assets equal to the value of such purchase
commitments will be maintained until payment is made. When issued and delayed
delivery agreements are subject to risks from changes in value, based upon
changes in the level of interest rates, currency rates and other market factors,
both before and after delivery. The Fund does not accrue any income on such
securities or currencies prior to their delivery. To the extent the Fund engages
in when issued and delayed delivery transactions, it will do so for the purpose
of acquiring portfolio securities or currencies consistent with its investment
objective and policies and not for the purpose of investment leverage. The Fund
currently does not intend to invest more than 5% of its assets in when issued or
delayed delivery transactions.
OPTIONS TRANSACTIONS
The Fund may enter into options transactions. Any premium paid by the Fund in
connection with an option transaction may be forfeited if the option expires
unexercised.
WRITING COVERED OPTIONS. The Fund may write (i.e., sell) covered call and
put options. By writing a call option, the Fund becomes obligated during the
term of the option to deliver the securities underlying the option upon payment
of the exercise price. By writing a put option, the Fund becomes obligated
during the term of the option to purchase the securities underlying the option
at the exercise price if the option is exercised. The Fund also may write
straddles (combinations of covered puts and calls on the same underlying
security).
The Fund may only write "covered" options. This means that so long as the
Fund is obligated as the writer of a call option, it will own the underlying
securities subject to the option or, in the case of call options on U.S.
Treasury bills, the Fund might own substantially similar U.S. Treasury bills.
The Fund will be considered "covered" with respect to a put option it writes if,
so long as it is obligated as the writer of the put option, it deposits and
maintains with its custodian in a segregated account liquid assets having a
value equal to or greater than the exercise price of the option.
The principal reason for writing call or put options is to obtain, through a
receipt of premiums, a greater current return than would be realized on the
underlying securities alone. The Fund receives a premium from writing a call or
put option which it retains whether or not the option is exercised. By writing a
call option, the Fund might lose the potential for gain on the underlying
security while the option is open, and by writing a put option, the Fund might
become obligated to purchase the underlying security for more than its current
market price upon exercise.
PURCHASING OPTIONS. The Fund does not currently intend to purchase put
options. The Fund may purchase call options for the purpose of offsetting
previously written call options of the same series. The Fund also may purchase
call options to fix the interest rates of obligations held by it. If the Fund is
unable to effect a closing purchase transaction with respect to covered options
it has written, the Fund will not be able to sell the underlying securities or
dispose of assets held in a segregated account until the options expire or are
exercised.
An option position may be closed out only in a secondary market for an
option of the same series. Although the Fund generally will write only those
options for which there appears to be an active secondary market, there is no
assurance that a liquid secondary market will exist for any particular option at
any particular time, and for some options no secondary market may exist. In such
event it might not be possible to effect a closing transaction in a particular
option.
Options on some securities are relatively new and it is impossible to
predict the amount of trading interest that will exist in such options. There
can be no assurance that viable markets will develop or continue. The failure of
such markets to develop or continue could significantly impair the Fund's
ability to use such options to achieve its investment objective.
The Fund currently does not intend to invest more than 5% of its assets in
options transactions.
OPTIONS TRADING MARKETS. Options which the Fund will trade are generally
listed on national securities exchanges. Exchanges on which such options
currently are traded are the Chicago Board Options Exchange and the New York,
American, Pacific and Philadelphia Stock Exchanges (Exchanges). Options on some
securities may not be listed on any Exchange but traded in the over-the-counter
market. Options traded in the over-the-counter market involve the additional
risk that securities dealers participating in such transactions could fail to
meet their obligations to the Fund. The use of options traded in the
over-the-counter market may be subject to limitations imposed by certain state
securities authorities. In addition to the limits on its use of options
discussed herein, the Fund is subject to the investment restrictions described
in this prospectus and in the statement of additional information.
The staff of the Securities and Exchange Commission is of the view that the
premiums which the Fund pays for the purchase of unlisted options and the value
of securities used to cover unlisted options written by the Fund are considered
to be invested in illiquid securities or assets for the purpose of calculating
whether the Fund is in compliance with its fundamental investment restriction
prohibiting it from investing more than 10% of its total assets in any
combination of illiquid assets and securities.
FUTURES TRANSACTIONS
The Fund may enter into currency and other financial futures contracts and
write options on such contracts. The Fund intends to enter into such contracts
and related options for hedging purposes. The Fund will enter into securities,
currencies or index-based futures contracts in order to hedge against changes in
interest or exchange rates or securities prices. A futures contract on
securities or currencies is an agreement to buy or sell securities or currencies
at a specified price during a designated month. A futures contract on a
securities index does not involve the actual delivery of securities, but merely
requires the payment of a cash settlement based on changes in the securities
index. The Fund does not make payment or deliver securities upon entering into a
futures contract. Instead, it puts down a margin deposit, which is adjusted to
reflect changes in the value of the contract and which continues until the
contract is terminated.
The Fund may sell or purchase currency and other financial futures
contracts. When a futures contract is sold by the Fund, the value of the
contract will tend to rise when the value of the underlying securities or
currencies declines and to fall when the value of such securities or currencies
increases. Thus, the Fund sells futures contracts in order to offset a possible
decline in the value of its securities or currencies. If a futures contract is
purchased by the Fund, the value of the contract will tend to rise when the
value of the underlying securities or currencies increases and to fall when the
value of such securities or currencies declines. The Fund intends to purchase
futures contracts in order to fix what is believed by Keystone to be a favorable
price and rate of return for securities or favorable exchange rate for
currencies the Fund intends to purchase.
The Fund also intends to purchase put and call options on currency and other
financial futures contracts for hedging purposes. A put option purchased by the
Fund would give it the right to assume a position as the seller of a futures
contract. A call option purchased by the Fund would give it the right to assume
a position as the purchaser of a futures contract. The purchase of an option on
a futures contract requires the Fund to pay a premium. In exchange for the
premium, the Fund becomes entitled to exercise the benefits, if any, provided by
the futures contract, but is not required to take any action under the contract.
If the option cannot be exercised profitably before it expires, the Fund's loss
will be limited to the amount of the premium and any transaction costs.
The Fund may enter into closing purchase and sale transactions in order to
terminate a futures contract and may sell put and call options for the purpose
of closing out its options positions. The Fund's ability to enter into closing
transactions depends on the development and maintenance of a liquid secondary
market. There is no assurance that a liquid secondary market will exist for any
particular contract or at any particular time. As a result, there can be no
assurance that the Fund will be able to enter into an offsetting transaction
with respect to a particular contract at a particular time. If the Fund is not
able to enter into an offsetting transaction, the Fund will continue to be
required to maintain the margin deposits on the contract and to complete the
contract according to its terms, in which case it would continue to bear market
risk on the transaction.
Although futures and related options transactions are intended to enable the
Fund to manage market, interest rate or exchange rate risk, unanticipated
changes in interest rates, exchange rates or market prices could result in
poorer performance than if it had not entered into these transactions. Even if
Keystone correctly predicts interest or exchange rate movements, a hedge could
be unsuccessful if changes in the value of the Fund's futures position did not
correspond to changes in the value of its investments. This lack of correlation
between the Fund's futures and securities or currencies positions may be caused
by differences between the futures and securities or currencies markets or by
differences between the securities or currencies underlying the Fund's futures
position and the securities or currencies held by or to be purchased for the
Fund. Keystone will attempt to minimize these risks through careful selection
and monitoring of the Fund's futures and options positions.
The Fund does not intend to use futures transactions for speculation or
leverage. The Fund has the ability to write options on futures, but intends to
write such options only to close out options purchased by the Fund. The Fund
will not change these policies without supplementing the information in its
prospectus and statement of additional information.
FOREIGN CURRENCY TRANSACTIONS
The Fund may invest in obligations denominated in foreign currencies. Thus,
the value of Fund shares will be affected by changes in exchange rates. As one
way of managing exchange rate risk, in addition to entering into currency
futures contracts, the Fund may enter into forward currency exchange contracts
(agreements to purchase or sell currencies at a specified price and date). The
exchange rate for the transaction (the amount of currency the Fund will deliver
or receive when the contract is completed) is fixed when the Fund enters into
the contract. The Fund usually will enter into these contracts to stabilize the
U.S. dollar value of a security it has agreed to buy or sell. The Fund intends
to use these contracts to hedge the U.S. dollar value of a security it already
owns, particularly if the Fund expects a decrease in the value of the currency
in which the foreign security is denominated. Although the Fund will attempt to
benefit from using forward contracts, the success of its hedging strategy will
depend on Keystone's ability to predict accurately the future exchange rates
between foreign currencies and the U.S. dollar. The value of the Fund's
investments denominated in foreign currencies will depend on the relative
strength of those currencies and the U.S. dollar, and the Fund may be affected
favorably or unfavorably by changes in the exchange rates or exchange control
regulations between foreign currencies and the dollar. Changes in foreign
currency exchange rates also may affect the value of dividends and interest
earned, gains and losses realized on the sale of securities and net investment
income and gains, if any, to be distributed to shareholders by the Fund.
Although the Fund does not currently intend to do so, the Fund may also purchase
and sell options related to foreign currencies. The Fund does not intend to
enter into foreign currency transactions for speculation or leverage.
<PAGE>
KEYSTONE CUSTODIAN
FAMILY OF FUNDS
*
B-1 High Grade Bond Fund
B-2 Diversified Bond Fund
B-4 High Income Bond Fund
K-1 Balanced Income Fund
K-2 Strategic Growth Fund
S-1 Blue Chip Stock Fund
S-3 Capital Growth Fund
S-4 Small Company Growth Fund
International Fund
Precious Metals Holdings
Tax Free Fund
Tax Exempt Trust
Liquid Trust
[Logo] KEYSTONE
Distributors, Inc.
200 Berkeley Street
Boston, Massachusetts 02116-5034
KTFF-P 5/94
10M
K E Y S T O N E
TAX FREE
FUND
[Logo]
PROSPECTUS AND
APPLICATION
<PAGE>
KEYSTONE TAX FREE FUND
STATEMENT OF ADDITIONAL INFORMATION
MAY 1, 1994
This statement of additional information is not a prospectus but relates
to, and should be read in conjunction with, the prospectus of Keystone Tax Free
Fund dated May 1, 1994. A copy of the prospectus may be obtained from Keystone
Distributors, Inc. ("KDI"), the Fund's principal underwriter ("Principal
Underwriter"), 200 Berkeley Street, Boston, Massachusetts 02116-5034 or your
broker-dealer.
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TABLE OF CONTENTS
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Page
The Fund's Objective and Policies 2
Investment Restrictions 2
Valuation of Securities 4
Sales Charges 5
Distribution Plan 7
Principal Underwriter 9
Trustees and Officers 10
Declaration of Trust 16
Investment Manager 17
Investment Adviser 19
Brokerage 21
Standardized Total Return
and Yield Quotations 23
Additional Information 24
Appendix A-1
Financial Statements F-1
Independent Auditors' Report F-24
<PAGE>
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THE FUND'S OBJECTIVE AND POLICIES
- --------------------------------------------------------------------------------
The Fund's investment objective is to provide shareholders with the highest
possible current income, exempt from federal income taxes, while preserving
capital. The Fund invests primarily in municipal bonds but also may invest in
certain other securities as described in the Appendix hereto and the "Additional
Investment Information" section of the Fund's prospectus.
FUNDAMENTAL NATURE OF INVESTMENT OBJECTIVE
The investment objective of the Fund is fundamental and may not be changed
without approval of the holders of a majority of the Fund's outstanding shares
(which means the lesser of (1) 67% of the shares represented at a meeting at
which more than 50% of the outstanding shares are represented or (2) more than
50% of the outstanding shares).
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INVESTMENT RESTRICTIONS
- --------------------------------------------------------------------------------
None of the restrictions enumerated in this paragraph may be changed
without a vote of the holders of a majority, as defined in the Investment
Company Act of 1940 (the "1940 Act"), of the Fund's outstanding shares. The Fund
will not do the following:
(1) purchase securities on margin, but the Fund may obtain such short-term
credits as may be necessary for the clearance of purchases and sales of
securities;
(2) make short sales of securities or maintain a short position, unless at
all times when a short position is open it owns an equal amount of such
securities or of securities which without payment of any further consideration
are convertible into or exchangeable for securities of the same issue as, and
equal in amount to, the securities sold short;
(3) borrow money, except that the Fund may (a) borrow money from banks for
emergency or extraordinary purposes in aggregate amounts up to one-third of its
net assets, and (b) enter into reverse repurchase agreements;
(4) pledge, mortgage or hypothecate its assets except to secure
indebtedness permitted by subparagraph (3) above, with pledged assets to be no
more than 15% of its total assets; the Fund understands that pledges in excess
of approximately 6% of its net assets would result in its inability to sell
additional shares in one state; however, the Fund has no present intention of
exceeding this limit;
<PAGE>
(5) purchase any security other than United States ("U.S.") government
securities of any issuer if as a result more than 25% of its total assets would
be invested in a single industry, including industrial development bonds from
the same facility or similar types of facilities; governmental issuers of
municipal bonds are not regarded as members of an industry and the Fund may
invest more than 25% of its assets in industrial development bonds;
(6) purchase any security, other than U.S. government securities, if as a
result more than 5% of the Fund's total assets would be invested in securities
of the issuer, or the Fund would hold more than 10% of the voting securities of
the issuer;
(7) invest for the purpose of exercising control over or management of any
company;
(8) invest in securities of other investment companies, except as part of a
merger, consolidation, purchase of assets or similar transaction approved by the
Fund's shareholders;
(9) purchase or sell commodities or commodity contracts or real estate,
except that it may purchase and sell securities secured by real estate and
securities of companies which invest in real estate, and may engage in currency
or other financial futures and related options transactions;
(10) act as an underwriter except to the extent that, in connection with
the disposition of its portfolio investments, it may be deemed to be an
underwriter under federal securities laws; or purchase securities which are not
readily marketable except for repurchase agreements;
(11) purchase or retain securities of an issuer if, to the knowledge of the
Fund, an officer, Trustee or Director of the Fund or Keystone owns beneficially
more than 1/2 of 1% of the shares or securities of such issuer and all such
officers, Trustees and Directors owning more than 1/2 of 1% of such shares or
securities together own more than 5% of such shares or securities;
(12) purchase securities of any issuer if the person responsible for
payment, together with any predecessor, has been in operation for less than
three years if, as a result, the aggregate of such investments would exceed 5%
of the Fund's total assets; provided, however, that this restriction shall not
apply to U.S. government securities or to any obligation the payment of which
involves the credit and taxing power of any person authorized to issue municipal
bonds;
<PAGE>
(13) invest in interests in oil, gas or other mineral exploration
or development programs;
(14) make loans, except to the extent that the purchase of debt instruments
or repurchase agreements may be deemed to be loans; repurchase agreements
maturing in more than seven days will not exceed 10% of the Fund's total assets;
and
(15) purchase securities of foreign issuers.
The foregoing percentage restrictions will apply at the time of the
purchase of a security and shall not be considered violated unless an excess or
deficiency occurs or exists immediately after and as a result of a purchase of
such security. For the purpose of limitations (5) and (6), the Fund will treat
each state, territory and possession of the U.S., the District of Columbia and,
if its assets and revenues are separate from those of the entity or entities
creating it, each political subdivision, agency and instrumentality of any one
(or more, as in the case of a multistate authority or agency) of the foregoing
as an issuer of all securities that are backed primarily by its assets or
revenues; each company as an issuer of all securities that are backed primarily
by its assets or revenues; and each of the foregoing entities as an issuer of
all securities that it guarantees; provided, however, that for the purpose of
limitation (6) no entity shall be deemed to be an issuer of a security that it
guarantees so long as no more than 10% of the Fund's total assets (taken at
current value) are invested in securities guaranteed by the entity and
securities of which it is otherwise deemed to be an issuer.
The Fund does not presently intend to invest more than 25% of its total
assets in (1) municipal bonds of a single state and its subdivisions, agencies
and instrumentalities; of a single territory or possession of the U.S. and its
subdivisions, agencies or instrumentalities; or of the District of Columbia and
any subdivision, agency or instrumentality thereof; or (2) municipal bonds the
payment of which depends on revenues derived from a single facility or similar
types of facilities. Since certain municipal bonds may be related in such a way
that an economic, business or political development or change affecting one such
security could likewise affect the other securities, a change in this policy
could result in increased investment risk, but no change is presently
contemplated. The Fund may invest more than 25% of its total assets in
industrial development bonds.
<PAGE>
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VALUATION OF SECURITIES
- --------------------------------------------------------------------------------
The Fund believes that reliable market quotations generally are not readily
available for purposes of valuing municipal bonds. As a result, depending on the
particular municipal bonds owned by the Fund, it is likely that most of the
valuations for such bonds will be based upon their fair value determined under
procedures which have been approved by the Board of Trustees. Non-tax exempt
securities for which market quotations are readily available are valued on a
consistent basis at that price quoted which, in the opinion of the Board of
Trustees or the person designated by the Board of Trustees to make the
determination, most nearly represents the market value of the particular
security. Short-term investments which are purchased with maturities of sixty
days or less are valued at amortized cost (original purchase cost as adjusted
for amortization of premium or accretion of discount) which, when combined with
accrued interest, approximates market; short-term investments maturing in more
than sixty days for which market quotations are readily available are valued at
current market value; and short-term investments maturing in more than sixty
days when purchased which are held on the sixtieth day prior to maturity are
valued at amortized cost (market value on the sixtieth day adjusted for
amortization of premium or accretion of discount) which, when combined with
accrued interest, approximates market and which in any case reflects fair value
as determined by the Board of Trustees. All other investments are valued at
market value or, where market quotations are not readily available, at fair
value as determined in good faith using methods prescribed by the Fund's Board
of Trustees.
- --------------------------------------------------------------------------------
SALES CHARGES
- --------------------------------------------------------------------------------
In order to reimburse the Fund for certain expenses relating to the sale of
its shares (see "Distribution Plan"), a contingent deferred sales charge may be
imposed at the time of redemption of certain Fund shares within four calendar
years after their purchase. If imposed, the contingent deferred sales charge is
deducted from the redemption proceeds otherwise payable to the shareholder.
Since July 8, 1992, the deferred sales charge attributable to shares purchased
prior to January 1, 1992 has been retained by the Fund, and the deferred sales
charge attributable to shares purchased after January 1, 1992 is, to the extent
permitted by a new rule adopted by the National Association of Securities
Dealers, Inc. ("NASD") paid to KDI, the Fund's Principal Underwriter.
Accordingly, for the fiscal year ended December 31, 1993, the Fund received
$373,564 and KDI received $482,452 in deferred sales charges.
The contingent deferred sales charge is a declining percentage of the
lesser of (1) the net asset value of the shares redeemed or (2) the total cost
of such shares. No contingent deferred sales charge is imposed when the
shareholder redeems amounts derived from (1) increases in the value of his
account above the total cost of such shares due to increases in the net asset
value per share of the Fund or (2) certain shares with respect to which the Fund
did not pay a commission on issuance, including shares acquired through
reinvestment of dividend income and capital gains distributions, or (3) shares
held in all or part of more than four consecutive calendar years.
<PAGE>
Subject to the limitations stated above, the Fund imposes a contingent
deferred sales charge according to the following schedule: 4% of amounts
redeemed during the calendar year of purchase; 3% of amounts redeemed during the
calendar year after the year of purchase; 2% of amounts redeemed during the
second calendar year after the year of purchase; and 1% of amounts redeemed
during the third calendar year after the year of purchase. No contingent
deferred sales charge is imposed on amounts redeemed thereafter.
The following example will illustrate the operation of the contingent
deferred sales charge. Assume that an investor makes a purchase payment of
$10,000 during the calendar year 1994 and on a given date in 1995 the value of
the investor's account has grown through investment performance and reinvestment
of distributions to $12,000. On such date in 1995 the investor could redeem up
to $2,000 ($12,000 minus $10,000) without incurring a deferred sales charge. If,
on such date, the investor should redeem $3,000, a deferred sales charge would
be imposed on $1,000 of the redemption (the amount by which the investor's
account was reduced by the redemption below the amount of the initial purchase
payment). The charge would be imposed at the rate of 3% because the redemption
is made during the calendar year after the calendar year of purchase, for a
total deferred sales charge of $30.
In determining whether a contingent deferred sales charge is payable and,
if so, the percentage charge applicable, it is assumed that shares held the
longest are the first to be redeemed. There is no contingent deferred sales
charge imposed on exchanges of shares between the Keystone Group of funds which
have adopted distribution plans pursuant to Rule 12b-1 under the 1940 Act.
Moreover, when shares of one such fund have been exchanged for shares of another
such fund, for purposes of any future contingent deferred sales charge, the
calendar year of the purchase of the shares of the fund exchanged into is
assumed to be the year shares tendered for exchange were originally purchased.
Shares also may be sold, to the extent permitted by applicable law,
regulations, interpretations or exemptions, at net asset value without the
imposition of a deferred sales charge upon redemption of shares to (1) officers,
Directors, Trustees, full-time employees and sales representatives of Keystone
Management, Inc. ("Keystone Management"), Keystone Custodian Funds, Inc.
("Keystone"), Keystone Group, Inc. ("Keystone Group"), Harbor Capital Management
Company, Inc., their subsidiaries and the Principal Underwriter who have been
such for not less than ninety days; and (2) the pension and profit-sharing plans
established by said companies, their subsidiaries and affiliates, for the
benefit of their officers, Directors, Trustees, full-time employees and sales
representatives, provided all such sales are made upon the written assurance of
the purchaser that the purchase is made for investment purposes and that the
securities will not be resold except through redemption by the Fund.
<PAGE>
In addition, no contingent deferred sales charge is imposed on a redemption
of shares of the Fund purchased by a bank or trust company in a single account
in the name of such bank or trust company as trustee, if the initial investment
in shares of the Fund, any Keystone Custodian Fund, Keystone Precious Metals
Holdings, Inc., Keystone International Fund Inc., Keystone Tax Exempt Trust,
Keystone Liquid Trust and/or any Keystone America Fund is at least $500,000 and
any commission paid by the Fund and such other funds at the time of such
purchase is not more than 1% of the amount invested.
- --------------------------------------------------------------------------------
DISTRIBUTION PLAN
- --------------------------------------------------------------------------------
Rule 12b-1 under the 1940 Act permits investment companies, such as the
Fund to use their assets to bear expenses of distributing their shares if they
comply with various conditions, including adoption of a distribution plan
containing certain provisions set forth in Rule 12b-1. On January 19, 1983, the
Fund's Distribution Plan described below was approved by the Fund's Board of
Trustees, including a majority of the Trustees who are not interested persons of
the Fund as defined in the 1940 Act ("Independent Trustees") and the Trustees
who have no direct or indirect financial interest in the Distribution Plan or
any agreement related thereto (the "Rule 12b-1 Trustees" who are the same as the
Independent Trustees). On May 27, 1983, the Distribution Plan was approved by
the Fund's shareholders, and it became effective on June 1, 1983.
The Fund's Distribution Plan provides that the Fund may expend up to
0.3125% quarterly (approximately 1.25% annually) of average daily net asset
value of its shares to pay distribution costs for sales of its shares and to pay
shareholder service fees. A new rule adopted by the NASD effective July 7, 1993
limits such annual expenditures to 1%, of which 0.75% may be used to pay such
distribution costs and 0.25% may be used to pay shareholder service fees. The
aggregate amount that the Fund may pay for such distribution costs is limited to
6.25% of gross share sales since the inception of the Fund's Distribution Plan
plus interest at the prime rate plus 1% on unpaid amounts thereof (less any
contingent deferred sales charge paid by shareholders to KDI). The Fund operates
its Distribution Plan in accordance with both the Distribution Plan and the NASD
rule.
In connection with the Distribution Plan, Fund shares are offered for sale
at net asset value without any initial sales charge, and the Fund pays or
accrues to the Principal Underwriter a commission for each sale. Specifically,
amounts paid or accrued under the Distribution Plan are paid or accrued to the
Fund's Principal Underwriter, currently KDI, as commissions for Fund shares sold
under the Distribution Plan, all or any part of which commissions may be
reallowed by KDI to others (dealers). In addition, the Fund pays to the
Principal Underwriter amounts sufficient for the Principal Underwriter to pay to
such others a service fee at a rate of 0.25% per annum of the net asset value of
the shares sold by such others that remain outstanding on the books of the Fund
for specified periods. Such commissions and service fees are included in the
Fund's operating expenses.
<PAGE>
If the Fund is unable to pay KDI a commission on a new sale because the
annual maximum (0.75% of average daily net assets) has been reached, KDI
intends, but is not obligated, to continue to accept new orders for the purchase
of Fund shares and to pay commissions and service fees to dealers in excess of
the amount it currently receives from the Fund. While the Fund is under no
contractual obligation to reimburse KDI for advances made by KDI in excess of
the Distribution Plan limitation, KDI intends to seek full payment of such
charges from the Fund (together with interest rate of prime plus one percent) at
such time in the future as, and to the extent that, payment thereof by the Fund
would be within permitted limits. KDI currently intends to seek payment of
interest only on such charges paid or accrued by KDI subsequent to January 1,
1992. If the Independent Trustees authorize such payments, the effect will be to
extend the period of time during which the Fund incurs the maximum amount of
costs allowed by the Distribution Plan. The Independent Trustees have agreed to
reimburse KDI such portion of this amount at such future time when the payment
of such amounts would not cause the Fund to exceed the Distribution Plan
limitation. If the Distribution Plan is terminated, KDI will ask the Independent
Trustees to take whatever action they deem appropriate under the circumstances
with respect to payment of such amounts.
The total amounts paid by the Fund under the foregoing arrangements may not
exceed the maximum Distribution Plan limit specified above, and the amounts and
purposes of expenditures under the Distribution Plan must be reported to the
Fund's Rule 12b-1 Trustees quarterly. The Fund's Rule 12b-1 Trustees may require
or approve changes in the implementation or operation of the Distribution Plan,
and may also require that total expenditures by the Fund under the Distribution
Plan be kept within limits lower than the maximum amount permitted by the
Distribution Plan as stated above. If such costs are not limited by the
Independent Trustees, such costs could, for some period of time, be higher than
such costs permitted by most other plans presently adopted by other investment
companies.
The Distribution Plan may be terminated at any time by vote of the Rule
12b-1 Trustees, or by vote of a majority of the outstanding voting securities of
the Fund. Any change in the Distribution Plan that would materially increase the
distribution expenses of the Fund provided for in the Distribution Plan requires
shareholder approval. Otherwise, the Distribution Plan may be amended by the
Trustees, including the Fund's Rule 12b-1 Trustees. The Fund's Board of
Trustees, including the Fund's 12b-1 Trustees, most recently approved the
continuance of the Fund's Distribution Plan at a meeting held on June 16, 1993.
<PAGE>
While the Distribution Plan is in effect, the Fund will be required to
commit the selection and nomination of candidates for Independent Trustees to
the discretion of the Independent Trustees.
During the fiscal year ended December 31, 1993, the Fund paid KDI
$16,608,165 under the Distribution Plan, of which $4,272,087 represented
repayment of advances. The amount paid by the Fund under its Distribution Plan,
net of deferred sales charges, was $16,234,601 (1.06% of the Fund's average
daily net asset value during the period). During the year, KDI retained
$9,241,496 and paid commissions on new sales and maintenance fees to dealers and
others of $7,366,669.
Whether any expenditure under the Distribution Plan is subject to a state
expense limit will depend upon the nature of the expenditure and the terms of
the state law, regulation or order imposing the limit. Any expenditure subject
to such a limit will be included in the Fund's total operating expenses for
purposes of determining compliance with the expense limit. A portion of the
Fund's Distribution Plan expenses may be includable in the Fund's total
operating expenses for purposes of determining compliance with state expense
limits.
Commissions paid on new sales of shares are treated as capital charges and
deferred sales charges received by the Fund are treated as capital credits,
respectively, in determining net investment income for tax purposes.
The Independent Trustees of the Fund have determined that the sales of the
Fund's shares resulting from payments under the Distribution Plan have benefited
the Fund.
- --------------------------------------------------------------------------------
PRINCIPAL UNDERWRITER
- --------------------------------------------------------------------------------
Pursuant to a Principal Underwriting Agreement (the "Underwriting
Agreement"), KDI acts as the Fund's Principal Underwriter. KDI, located at 200
Berkeley Street, Boston, Massachusetts 02116-5034, is a Delaware corporation
wholly-owned by Keystone. KDI as agent has agreed to use its best efforts to
find purchasers for the shares. KDI may retain and employ representa-tives to
promote distribution of the shares and may obtain orders from brokers, dealers
and others, acting as principals, for sales of shares to them. The Underwriting
Agreement provides that KDI will bear the expense of preparing, printing and
distributing advertising and sales literature and prospectuses used by it. In
its capacity as principal underwriter, KDI may receive payments from the Fund
pursuant to the Fund's Distribution Plan.
<PAGE>
The Underwriting Agreement provides that it will remain in effect as long
as its terms and continuance are approved by a majority of the Fund's
Independent Trustees at least annually at a meeting called for that purpose, and
if its continuance is approved annually by vote of a majority of Trustees, or by
vote of a majority of the outstanding shares. The terms of the Underwriting
Agreement and such continuance were most recently approved by the Board of
Trustees, including a majority of Independent Trustees, at a meeting held on
June 16, 1993.
The Underwriting Agreement may be terminated, without penalty, on 60 days'
written notice by the Board of Trustees or by a vote of a majority of
outstanding shares. The Underwriting Agreement will terminate automatically upon
its "assignment" as that term is defined in the 1940 Act.
From time to time, if in KDI's judgment it could benefit the sales of Fund
shares, KDI may use its discretion in providing to selected dealers promotional
materials and selling aids, including, but not limited to, personal computers,
related software and Fund data files.
For the fiscal years ended December 31, 1991, 1992 and 1993 KDI earned
commissions of $1,089,500, $7,972,003 and $4,969,409 (amount represents
commissions earned during the fiscal year ended December 31, 1993 and excludes
recapture by KDI during said fiscal year of $4,272,087 in advances made during
previous fiscal years), respectively, after paying commissions of $5,637,096,
$7,260,876 and $3,705,342 (amount represents sales commissions only and excludes
$3,661,327 in maintenance fees paid during the fiscal year), respectively, to
retail dealers under the Distribution Plan. See "Distribution Plan" section of
this document for additional information.
- --------------------------------------------------------------------------------
TRUSTEES AND OFFICERS
- --------------------------------------------------------------------------------
The Trustees of the Fund, their principal occupations and some of their
affiliations over the last five years, and the Officers of the Fund are as
follows:
*GEORGE S. BISSELL: Chairman of the Board, Trustee and Chief Executive Officer
of the Fund; Chairman of the Board, Director and Chief Executive
Officer of Keystone Group, Keystone, Keystone Manage- ment, Keystone
Software Inc., Keystone Nevada, Inc., Keystone Fixed Income Advisers,
Inc. ("KFIA") and KIRC; Chairman of the Board, Chief Executive Officer
and Trustee or Director of Keystone America Capital Preservation and
Income Fund, Keystone America Capital Preservation and Income Fund II,
Keystone America Equity Income Fund, Keystone America Global
Opportunities Fund, Keystone America Government Securities Fund,
Keystone America Intermediate Term Bond Fund, Keystone America Omega
Fund, Inc., Keystone America State Tax Free Fund; Keystone America
Strategic Income Fund, Keystone America Tax Free Income Fund, Keystone
America World Bond Fund, Keystone Australia Funds, Inc., Keystone
America Hartwell Emerging Growth Fund, Inc.; Keystone America Hartwell
Growth Fund, Inc. and Keystone Fund of the Americas (collectively,
"Keystone America Funds"); Keystone Custodian Funds, Series B-1, B-2,
B-4, K-1, K-2, S-1, S-3 and S-4 (collectively, "Keystone Custodian
Funds"); Keystone Institutional Adjustable Rate Fund, Keystone
International Fund Inc., Keystone Liquid Trust, Keystone Precious
Metals Holdings, Inc., Keystone Tax Exempt Trust, Keystone Tax Free
Fund, Master Reserves Trust and Master Reserves Tax Free Trust (all
such funds, collectively, "Keystone Group Funds"); Chairman of the
Board, Hartwell Keystone Advisers, Inc. ("Hartwell Keystone"); Director
of Keystone Investment Management Corporation ("KIMCO"); Chairman of
the Board and Trustee of Anatolia College; and Trustee of University
Hospital (and Chairman of its Investment Committee).
<PAGE>
FREDERICK AMLING: Trustee of the Fund; Trustee or Director of all other Keystone
Group Funds; Professor, Finance Department, George Washington
University; President, Amling & Company (investment advice); Member,
Board of Advisers, Credito Emilano (banking); and former Economics and
Financial Consultant, Riggs National Bank.
CHARLES A. AUSTIN III: Trustee of the Fund; Trustee or Director of all other
Keystone Group Funds; Managing Director, Seaward Management Corporation
(investment advice); and former Director, Executive Vice President and
Treasurer, State Street Research & Management Company (investment
advice).
*ALBERT H. ELFNER, III: President and Trustee of the Fund; Director and Vice
Chairman of Keystone; Chief Operating Officer, President and Director
of Keystone Group; Chairman of the Board and Director of KIMCO and
KFIA; President and Director of Keystone Management, Hartwell Keystone
and Keystone Software, Inc.; Director of KDI, KIRC, Fiduciary
Investment Company, Inc. ("FICO") and Robert Van Partners, Inc.;
President of Keystone Nevada, Inc.; President and Trustee or Director
of all other Keystone Group Funds; Director of Boston Children's
Services Association and Trustee of Anatolia College, Middlesex School,
Middlebury College and Citizens Bank; Member, Board of Governors, New
England Medical Center; former Director and President of Harbor
Keystone Advisers, Inc.; and former President of Keystone.
EDWIN D. CAMPBELL: Trustee of the Fund; Trustee or Director of all other
Keystone Group Funds; Executive Director, Coalition of Essential
Schools, Brown University; Director and former Executive Vice
President, National Alliance of Business; former Vice President,
Educational Testing Services; and former Dean, School of Business,
Adelphi University.
CHARLES F. CHAPIN: Trustee of the Fund; Trustee or Director of all other
Keystone Group Funds; former Group Vice President, Tex-tron Corp.; and
former Director, Peoples Bank.
LEROY KEITH, JR.: Trustee of the Fund; Trustee or Director of all other
Keystone Group Funds; President, Morehouse College; Director of Phoenix
Total Return Fund and Equifax, Inc.; Trustee of Phoenix Series Fund,
Phoenix Multi-Portfolio Fund and The Phoenix Big Edge Series Fund.
K. DUN GIFFORD: Trustee of the Fund; Trustee or Director of all other
Keystone Group Funds; Chairman of the Board, Director and Executive
Vice President, The London Harness Company; Managing Partner, Roscommon
Capital Corp.; Trustee, Cambridge College; Chairman Emeritus and
Director, American Institute of Food and Wine; Chief Executive Officer,
Gifford Gifts of Fine Foods; Chairman, Gifford, Drescher & Associates
(environmental consult- ing); President, Oldways Preservation and
Exchange Trust (educa- tion); and former Director, Keystone Group and
Keystone.
F. RAY KEYSER, JR.: Trustee of the Fund; Trustee or Director of all other
Keystone Group Funds; Of Counsel, Keyser, Crowley & Meub, P.C.; Member,
Governor's (VT) Council of Economic Advisers; Chairman of the Board and
Director, Central Vermont Public Service Corporation and Hitchcock
Clinic; Director, Vermont Yankee Nuclear Power Corporation, Vermont
Electric Power Company, Inc., Grand Trunk Corporation, Central Vermont
Railway, Inc., S.K.I. Ltd., Sherburne Corporation, Union Mutual Fire
Insurance Company, New England Guaranty Insurance Company, Inc. and the
Investment Company Institute; former Governor of Vermont; former
Director and President, Associated Industries of Vermont; former
Chairman and President, Vermont Marble Company; former Director of
Keystone; and former Director and Chairman of the Board, Green Mountain
Bank.
<PAGE>
DAVID M. RICHARDSON: Trustee of the Fund; Trustee or Director of all other
Keystone Group Funds; Executive Vice President, DHR International, Inc.
(executive recruitment); former Senior Vice President, Boyden
International Inc. (executive recruitment); and Director, Commerce and
Industry Association of New Jersey, 411 International, Inc. and J & M
Cumming Paper Co.
RICHARD J. SHIMA: Trustee of the Fund; Trustee or Director of all other
Keystone Group Funds; Consultant, Russell Miller, Inc. (investment
bankers) and Consultant, Drake Beam Morin, Inc. (executive
outplacement); Director of Connecticut Natural Gas Corporation, Trust
Company of Connecticut, Hartford Hospital, Old State House Association
and Enhanced Financial Services, Inc.; Member, Georgetown College Board
of Advisors; Chairman, Board of Trustees, Hartford Graduate Center;
Trustee, Kingswood-Oxford School and Greater Hartford YMCA; former
Director, Executive Vice President and Vice Chairman of The Travelers
Corporation; and former Managing Director of Russell Miller, Inc.
ANDREW J. SIMONS: Trustee of the Fund; Trustee or Director of all other Keystone
Group Funds; Partner, Farrell, Fritz, Caemmerer, Cleary, Barnosky &
Armentano, P.C.; President, Nassau County Bar Association; former
Associate Dean and Professor of Law, St. John's University School of
Law.
EDWARD F. GODFREY: Senior Vice President of the Fund; Senior Vice President of
all other Keystone Group Funds; Senior Vice President, Chief Financial
Officer and Treasurer of Keystone Group and KDI; Director, Senior Vice
President, Chief Financial Officer and Treasurer of Keystone; Treasurer
of KIMCO, Keystone Management, Keystone Software, Inc. and FICO; and
Treasurer and Director of Hartwell Keystone.
JAMES R. McCALL: Senior Vice President of the Fund; Senior Vice President of all
other Keystone Group Funds; and President of Keystone.
ROGER T. WICKERS: Senior Vice President of the Fund; Senior Vice President of
all other Keystone Group Funds; Director, Senior Vice President,
General Counsel and Secretary, Keystone Group and KDI; Director and
Secretary, Keystone; and Vice President, Assistant Secretary and
Director, Keystone Management.
THOMAS S. DRUMM: Vice President of the Fund; Senior Vice President of Keystone;
and Vice President of 11 Keystone America Funds; 2 other Keystone Group
Funds; 4 Keystone Custodian Funds and Keystone Institutional Adjustable
Rate Fund.
BETSEY A. BLACHER: Vice President of the Fund; Vice President of Keystone and
Vice President of one other Keystone Group Fund and 2 Keystone America
Funds.
ROSEMARY D. VAN ANTWERP: Vice President and Secretary of the Fund; Vice
President and Secretary of all other Keystone Group Funds; Senior Vice
President and General Counsel of Keystone, Keystone Management,
Hartwell Keystone, KIRC, KFIA, Keystone Software, Inc. and KIMCO; Vice
President, Assistant Secretary and Associate General Counsel of
Keystone Group; Senior Vice President, General Counsel, Director and
Assistant Clerk, FICO; Assistant Secretary of KDI; and former Vice
President of Harbor Keystone Advisers, Inc.
<PAGE>
KEVIN J. MORRISSEY: Treasurer of the Fund; Treasurer of all other Keystone Group
Funds; Vice President of Keystone Group; and former Vice President and
Treasurer of KIRC.
* This Trustee may be considered an "interested person" within the meaning of
the 1940 Act.
Mr. Bissell and Mr. Elfner are "interested persons" by virtue of their
positions as officers and/or Directors of Keystone Group and several of their
affiliates including Hartwell Keystone, KDI and KIRC. Mr. Bissell and Mr. Elfner
own shares of Keystone Group. Mr. Bissell is Chairman of the Board, Chief
Executive Officer and Director of Keystone Group. Mr. Elfner is President,
Director and Chief Operating Officer of Keystone Group.
The Board of Trustees of the Fund has established an Advisory Board composed
principally of former Trustees. The members of the Advisory Board are James R.
Dempsey, Knight Edwards, Donald T. Ellis, John M. Haffenreffer, Philip B.
Harley, Everett P. Pope, John W. Sharp, Spencer R. Stuart, Russel R. Taylor, and
Charles M. Williams. The Advisory Board will advise the Board of Trustees and
Keystone with respect to the management and operation of the Fund. The
recommendations of the Advisory Board will be considered by the Board of
Trustees and Keystone, but will not be binding on them.
The principal occupations and affiliations of the members of the
Advisory Board over the past five years are set forth below:
JAMES R. DEMPSEY: a private investor; Director or Trustee, Convest Energy
Corporation, Superior Electric Co., Phoenix Total Return Fund, Phoenix
Multi-Portfolio Fund, Phoenix Series Fund, The Phoenix Big Edge Series
Fund; former Chairman of the Board, Transatlantic Investment Capital
Corporation, Transatlantic Capital Corporation and former Trustee or
Director of 7 Keystone Group Funds.
KNIGHT EDWARDS: Of Counsel, Edwards & Angell; Member of the Board of Managers
of 7 variable annuity separate accounts of The Travelers Insurance
Company ("Travelers"); Trustee, 5 mutual funds sponsored by Travelers;
Funds for variable annuity or life insurance products; and former
Trustee or Director of 8 Keystone
Group Funds.
DONALD T. ELLIS: President, D.T. Ellis Associates; Associate, Michael Saunders
& Co., real estate broker; former Senior Vice President, Goldman
Financial Services, Inc.; former President, Chief Executive Officer and
Treasurer, Scott Seaboard Corporation and former Trustee or Director of
8 Keystone Group Funds.
JOHN M. HAFFENREFFER: Vice President, Director and Treasurer of Haffenreffer &
Co.; Member of the Corporation and Treasurer of Haffenreffer Benevolent
Corp.; Director and Member of the Executive Committee of Liberty Bank
and Trust Company; Director of the Massachusetts Council of Churches;
Vice President, Director and Treasurer, Forest Hills Company; former
Director of Keystone; and former Trustee or Director of all Keystone
Group Funds.
<PAGE>
PHILIP B. HARLEY: Director of General Host Corporation, Stamford, Connecticut;
a private investor; former Director, President and Chief Executive
Officer, Baker Perkins, Inc.; former Director, Baker Perkins Holdings
Ltd. (U.K.); and former Trustee or Director of all Keystone Group
Funds.
EVERETT P. POPE: former Chairman and Trustee, Bowdoin College; former Chairman
of the Board and President of Workingmens Cooperative Bank; former
Chairman, Massachusetts Higher Education Assistance Corporation
(guarantor of student loans); and former Trustee or Director of all
Keystone Group Funds.
JOHN W. SHARP: Governor and past President of Montreal General Hospital,
Canada; Honorary Vice Chairman and former National President of Boy
Scouts of Canada; Honorary Colonel, The Black Watch Royal Highland
Regiment of Canada; former Director of Keystone, Unimed, Inc.; former
Chairman and President, Vilas Industries, Ltd. (Canada); former
Chairman, Moyer School supplies, Ltd. (Canada); former Senior Econ omic
Adviser, Province of Quebec, in New York City; former registered
representative with F.H. Deacon Hodgson Ltd.; and former Trustee or
Director of all Keystone Group Funds.
SPENCER R. STUART: Director of U.S. Tobacco Company, Asset Guaranty Inc.,
International Finance Group and Enhanced Financial Services Inc.;
Director and Chairman, Human Resources Committee, Allegheny
International, Inc.; former Director of Western Airlines, Inc.,
International Finance Group and Keystone; former Chairman, Council of
Managing Advisers, Dean Witter Reynolds Bank; Founder/former Chairman
of Spencer Stuart & Associates; and former Trustee or Director of all
Keystone Group Funds.
RUSSEL R. TAYLOR: Trustee of the Gintel Funds, Greenwich, Connecticut; Associate
Professor and Director, H.W. Taylor Institute of Entrepreneurial
Studies, College of New Rochelle; former Director of Annis Furs, Inc.,
Minnetonka, Inc.; and former Trustee or Director of all Keystone Group
Funds.
CHARLES M. WILLIAMS: Director, Horace Mann Educator Corp.; President, Charles M.
Williams Associates; Advisory Director, Orix U.S. A., Inc.; Director of
Fort Dearborn Income Securities, Inc., 4 Merrill Lynch Funds, National
Life Insurance Company of Vermont and Institute for Financial
Management, Inc.; President of Charles M. Williams Associates, Inc.;
George Gund Professor of Commercial Banking, Emeritus, at Harvard
University Graduate School of Business Administration; former Director
of Keystone, Hammermill Paper Co., Sonat, Inc., United States Leasing
International, Inc.; and former Trustee or Director of all Keystone
Custodian Funds and Keystone America Funds.
During the fiscal year ended December 31, 1993, none of the affiliated
Trustees and officers of the Fund received any direct remuneration from the
Fund. During this same period the nonaffiliated Trustees and Advisory board
members received $68,158 in retainers and fees. On January 31, 1994, the
Trustees, officers and members of the Advisory Board of the Fund, as a group,
beneficially owned less than 1% of the Fund's then outstanding shares.
The address of all the Fund's Trustees, officers and Advisory Board Members
is 200 Berkeley Street, Boston, Massachusetts 02116- 5034.
<PAGE>
- --------------------------------------------------------------------------------
DECLARATION OF TRUST
- --------------------------------------------------------------------------------
The Fund is a Massachusetts business trust originally established under a
Declaration of Trust dated April 12, 1977. On July 27, 1993, the Fund's
Declaration of Trust was amended and restated in its entirety (the "Declaration
of Trust"). The Fund is similar in most respects to a business corporation. The
principal distinction between the Fund and a corporation relates to the
shareholder liability described below. A copy of the Declaration of Trust is
filed as an exhibit to Post-Effective No. 24 to the Fund's Registration
Statement of which this statement of additional information is a part. This
summary is qualified in its entirety by reference to the Declaration of Trust.
SHAREHOLDER LIABILITY
Pursuant to certain decisions of the Supreme Judicial Court of
Massachusetts, shareholders of a Massachusetts business trust may, under certain
circumstances, be held personally liable as partners for the obligations of the
trust. Even if, however, the Fund were held to be a partnership, the possibility
of the shareholders incurring financial loss for that reason appears remote
because the Fund's Declaration of Trust contains an express disclaimer of
shareholder liability for obligations of the Fund and requires that notice of
such disclaimer be given in each agreement, obligation or instrument entered
into or executed by the Fund or the Trustees, and because the Declaration of
Trust provides for indemnification out of the trust property for any shareholder
held personally liable for the obligations of the Fund.
VOTING RIGHTS
Under the terms of the Declaration of Trust, shares are entitled to vote in
the election of Trustees and on other matters and no amendment may be made to
the Declaration of Trust without the approval of the shareholders of the Fund.
Shares have non-cumulative voting rights, which means that the holders of more
than 50% of the shares voting for the election of Trustees can elect 100% of the
Trustees to be elected at a meeting, and, in such event, the holders of the
remaining less than 50% of the shares will not be able to elect any Trustees.
LIMITATION OF TRUSTEES' LIABILITY
The Declaration of Trust provides that a Trustee shall be liable only for
his own willful defaults and, if reasonable care has been exercised in the
selection of officers, agents, employees or investment advisers, shall not be
liable for any neglect or wrongdoing of any such person; provided, however, that
nothing in the Declaration of Trust shall protect a Trustee against any
liability for his willful misfeasance, bad faith, gross negligence or reckless
disregard of his duties.
- --------------------------------------------------------------------------------
INVESTMENT MANAGER
- --------------------------------------------------------------------------------
Subject to the general supervision of the Fund's Board of Trustees, Keystone
Management, located at Nevada Financial Center, 3800 Howard Hughes Parkway, Las
Vegas, Nevada 89109, serves as investment manager to the Fund and is responsible
for the overall management of the Fund's business and affairs. Keystone
Management, organized in 1989, is a wholly-owned subsidiary of Keystone and its
directors and principal executive officers have been affiliated with Keystone, a
seasoned investment adviser, for a number of years. Keystone Management also
serves as investment manager to each of the Keystone Custodian Funds and to
certain other Keystone funds.
Except as otherwise noted below, pursuant to an Investment Management
Agreement with the Fund (the "Management Agreement") and subject to the
supervision of the Fund's Board of Trustees, Keystone Management manages and
administers the operation of the Fund, and manages the investment and
reinvestment of the Fund's assets in conformity with the Fund's investment
objectives and restrictions. The Management Agreement stipulates that Keystone
Management shall provide office space, all necessary office facilities,
equipment and personnel in connection with its services under the Management
Agreement and pay or reimburse the Fund for the compensation of Fund officers
and trustees who are affiliated with the investment manager as well as pay all
expenses of Keystone Management incurred in connection with the provisions of
its services. All charges and expenses other than those specifically referred to
as being borne by Keystone Management will be paid by the Fund, including, but
not limited to, custodian charges and expenses; bookkeeping and auditors'
charges and expenses; transfer agent charges and expenses; fees of Independent
Trustees; brokerage commissions, brokers' fees and expenses; issue and transfer
taxes; costs and expenses under the Distribution Plan; taxes and trust fees
payable to governmental agencies; the cost of share certificates; fees and
expenses of the registration and qualification of the Fund and its shares with
the Securities and Exchange Commission (sometimes referred to herein as the
"SEC" or the "Commission") or under state or other securities laws; expenses of
preparing, printing and mailing prospectuses, statements of additional
information, notices, reports and proxy materials to shareholders of the Fund;
expenses of shareholders' and trustees' meetings; charges and expenses of legal
counsel for the Fund and for the Trustees of the Fund on matters relating to the
Fund; charges and expenses of filing annual and other reports with the SEC and
other authorities; and all extraordinary charges and expenses of the Fund.
Keystone Management pays all charges and expenses relating to these items
subject to reimbursement by the Fund.
The Management Agreement permits Keystone Management to enter into an
agreement with Keystone or another investment adviser, under which Keystone or
such other investment adviser, as investment adviser, will provide substantially
all the services to be provided by Keystone Management under the Management
Agreement. The Management Agreement also permits Keystone Management to delegate
to Keystone or another investment adviser substantially all of the investment
manager's rights, duties and obligations under the Management Agreement.
Keystone Management provides the Fund with certain administrative and management
services, which services include (1) performing research and planning with
respect to (a) the Fund's qualification as a regulated investment company under
Subchapter M of the Internal Revenue Code, (b) tax treatment of the Fund's
portfolio investments, (c) tax treatment of special corporate actions (such as
reorganizations), (d) state tax matters affecting the Fund, and (e) the Fund's
distributions of income and capital gains; and (2) preparing the Fund's federal
and state tax returns; (3) providing services to the Fund's shareholders in
connection with federal and state taxation and distributions of income and
capital gains; and (4) storing documents relating to the Fund's activities.
The Fund pays Keystone Management at the end of each calendar month a fee
for its services consisting of (1) an amount calculated as set forth below:
ANNUAL AGGREGATE NET
MANAGEMENT ASSET VALUE OF THE
FEE INCOME SHARES OF THE FUND
- --------------------------------------------------------------------------------
2.0% of
Gross Dividend and
Interest Income
Plus
0.50% of the first $100,000,000, plus
0.45% of the next $100,000,000, plus
0.40% of the next $100,000,000, plus
0.35% of the next $100,000,000, plus
0.30% of the next $100,000,000, plus
0.25% of amounts over $500,000,000; and
(2) an amount equal to Keystone Management's reimbursable expenses accrued
during such calendar month.
As a continuing condition of registration of shares in a state, Keystone
Management has agreed to reimburse the Fund annually for certain operating
expenses incurred by the Fund in excess of certain percentages of the Fund's
average daily net assets. However, Keystone Management is not required to make
such reimbursements to an extent which would result in the Fund's inability to
qualify as a regulated investment company under provisions of the Internal
Revenue Code. This condition may be modified or eliminated in the future.
The Management Agreement continues in effect from year to year only if
approved at least annually by the Fund's Board of Trustees or by a vote of a
majority of the outstanding shares, and such renewal has been approved by the
vote of a majority of the Independent Trustees cast in person at a meeting
called for the purpose of voting on such approval. The Management Agreement may
be terminated, without penalty by the Fund's Board of Trustees or by a vote of a
majority of outstanding shares on 60 days' written notice to Keystone, and by
Keystone on 90 days' written notice to the Fund. The Management Agreement will
terminate automatically upon its "assignment" as that term is defined in the
1940 Act.
For additional discussion of fees paid to Keystone Management, see
"Investment Adviser" below.
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INVESTMENT ADVISER
- --------------------------------------------------------------------------------
Pursuant to the Management Agreement, Keystone Management has delegated its
investment management functions, except for certain administrative and
management services to be performed in Nevada, to Keystone and has entered into
an Investment Advisory Agreement (the "Advisory Agreement"), with Keystone under
which Keystone provides investment advisory and management services to the Fund.
Keystone, located at 200 Berkeley Street, Boston, Massachusetts 02116-5034,
has provided investment advisory and management services to investment companies
and private accounts since it was organized in 1932. Keystone is a wholly-owned
subsidiary of Keystone Group, 200 Berkeley Street, Boston, Massachusetts
02116-5034.
Keystone Group is a corporation privately owned by members of Keystone's
management and its affiliates. The shares of Keystone Group common stock
beneficially owned by management are held in a number of voting trusts, the
trustees of which are George S. Bissell, Albert H. Elfner, III, Roger T.
Wickers, Edward F. Godfrey and Ralph J. Spuehler, Jr. Keystone Group provides
accounting, bookkeeping, legal, personnel and general corporate services to
Keystone Management, Keystone, their affiliates and the Keystone Group of Mutual
Funds.
Pursuant to the Advisory Agreement, Keystone receives for its services an
annual fee representing 85% of the management fee received by Keystone
Management under its Management Agreement.
Under the terms of the Advisory Agreement and subject to the supervision of
the Fund's Board of Trustees, Keystone manages and administers the operation of
the Fund, and manages the investment and reinvestment of the Fund's assets in
conformity with the Fund's investment objectives and restrictions. The Advisory
Agreement stipulates that Keystone shall provide office space, all necessary
office facilities, equipment and personnel in connection with its services under
the Advisory Agreement and pay or reimburse the Fund for the compensation of
Fund officers and trustees who are affiliated with the investment manager and
will pay all expenses of Keystone incurred in connection with the provision of
its services. All charges and expenses other than those specifically referred to
as being borne by Keystone will be paid by the Fund, including, but not limited
to, custodian charges and expenses; bookkeeping and auditors' charges and
expenses; transfer agent charges and expenses; fees of Independent Trustees;
brokerage commissions, brokers' fees and expenses; issue and transfer taxes;
costs and expenses under the Distribution Plan; taxes and trust fees payable to
governmental agencies; the cost of share certificates, fees and expenses of the
registration and qualification of the Fund and its shares with the SEC or under
state or other securities laws; expenses of preparing, printing and mailing
prospectuses, statements of additional information, notices, reports and proxy
materials to shareholders of the Fund; expenses of shareholders' and Trustees'
meetings; charges and expenses of legal counsel for the Fund and for the
Trustees of the Fund on matters relating to the Fund; charges and expenses of
filing annual and other reports with the SEC and other authorities; and all
extraordinary charges and expenses of the Fund.
During the fiscal year ended December 31, 1991, the Fund paid or accrued to
Keystone Management investment management fees of $5,070,777 which represented
0.47% of the Fund's average net assets. Of such amount paid to Keystone
Management, $4,310,160 was paid to Keystone for its services to the Fund. In
addition, the Fund reimbursed Keystone Management $1,506,030, which represented
0.04% of the Fund's average net assets, in connection with reimbursable expenses
paid by Keystone Management on behalf of the Fund under the Investment
Management Agreement. For the fiscal year ended December 31, 1991, the total fee
paid to Keystone Management by the Fund for investment management and
administrative services fees was $6,576,807, which represented 0.51% of the
Fund's average net assets.
During the fiscal year ended December 31, 1992, the Fund paid or accrued to
Keystone Management investment management fees of $5,483,861, which represented
0.46% of the Fund's average net assets. Of such amount paid to Keystone
Management, $4,661,282 was paid to Keystone for its services to the Fund. In
addition, the Fund reimbursed Keystone Management $1,570,163, which represented
0.13% of the Fund's average net assets, in connection with reimbursable expenses
paid by Keystone Management on behalf of the Fund under the Investment
Management Agreement. For the fiscal year ended December 31, 1992, the total fee
paid to Keystone Management by the Fund for investment management and
administrative services fees was $7,054,024 which represented 0.59% of the
Fund's average net assets.
During the fiscal year ended December 31, 1993, the Fund paid or accrued to
Keystone Management investment management fees of $6,507,055, which represented
0.43% of the Fund's average net assets. Of such amount paid to Keystone
Management, $5,530,997 was paid to Keystone for its servies to the Fund. In
addition, the Fund reimbursed Keystone Management $2,488,890, which represented
0.16% of the Fund's average net assets, in connection with reimbursable expenses
paid by Keystone Management on behalf of the Fund under the Investment
Management Agreement. For the fiscal year ended December 31, 1993, the total fee
paid to Keystone Management by the Fund for investment management and
administrative services fees was $8,995,945 which represented 0.59% of the
Fund's average net assets.
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BROKERAGE
- --------------------------------------------------------------------------------
It is the policy of the Fund, in effecting transactions in portfolio
securities, to seek best execution of orders at the most favorable prices. The
determination of what may constitute best execution and price in the execution
of a securities transaction by a broker involves a number of considerations
including, without limitation, the overall direct net economic result to the
Fund, involving both price paid or received and any commissions and other costs
paid, the efficiency with which the transaction is effected, the ability to
effect the transaction at all where a large block is involved, the availability
of the broker to stand ready to execute potentially difficult transactions in
the future and the financial strength and stability of the broker. Such
considerations are judgmental and are weighed by management in determining the
overall reasonableness of brokerage commissions paid.
Subject to the foregoing, a factor in the selection of brokers is the
receipt of research services, such as analyses and reports concerning issuers,
industries, securities, economic factors and trends and other statistical and
factual information. Any such research and other statistical and factual
information provided by brokers to the Fund, Keystone Management or Keystone is
considered to be in addition to and not in lieu of services required to be
performed by Keystone Management under the Management Agreement with the Fund or
Keystone under the Advisory Agreement with Keystone Management. The cost, value
and specific application of such information are indeterminable and cannot be
practically allocated among the Fund and other clients of Keystone Management or
Keystone who may indirectly benefit from the availability of such information.
Similarly, the Fund may indirectly benefit from information made available as a
result of transactions effected for such other clients. Under the Management
Agreement and the Advisory Agreement, Keystone Management and Keystone are
permitted to pay higher brokerage commissions for brokerage and research
services in accordance with Section 28(e) of the Securities Exchange Act of
1934. In the event Keystone Management and Keystone do follow such a practice,
they will do so on a basis which is fair and equitable to the Fund.
The Fund's securities transactions are generally principal transactions with
the issuer of the security or with major underwriters and dealers for municipal
bonds. Accordingly, the Fund does not pay significant brokerage commissions. The
cost of securities purchased from underwriters includes an underwriting
commission or concession and the prices at which securities are purchased from
and sold to dealers include a dealer's mark-up or mark- down. Purchases from
underwriters will include the underwriting commission or concession and
purchases from dealers serving as market makers will include the spread between
the bid and asked prices. Where transactions are made in the over-the-counter
market, the Fund will deal with primary market makers unless more favorable
prices are otherwise obtainable.
The Fund may participate, if and when practicable, in group bidding for the
purchase directly from an issuer of certain securities for the Fund's portfolio
in order to take advantage of the lower purchase price available to members of
such a group.
Neither Keystone Management, Keystone nor the Fund intend to place
securities transactions with any particular broker-dealer or group thereof.
However, the Fund's Board of Trustees has determined that the Fund may follow a
policy of considering sales of shares as a factor in the selection of
broker-dealers to execute portfolio transactions, subject to the requirements of
best execution, including best price, described above.
The policy of the Fund with respect to brokerage is and will be reviewed by
the Fund's Board of Trustees from time to time. Because of the possibility of
further regulatory developments affecting the securities exchanges and brokerage
practices generally, the foregoing practices may be changed, modified or
eliminated.
Investment decisions for the Fund are made independently by Keystone
Management or Keystone from those of the other funds and investment accounts
managed by Keystone Management or Keystone. It may frequently develop that the
same investment decision is made for more than one fund. Simultaneous
transactions are inevitable when the same security is suitable for the
investment objective of more than one account. When two or more funds or
accounts are engaged in the purchase or sale of the same security, the
transactions are allocated as to amount in accordance with a formula which is
equitable to each fund or account. It is recognized that in some cases this
system could have a detrimental effect on the price or volume of the security as
far as the Fund is concerned. In other cases, however, it is believed that the
ability of the Fund to participate in volume transactions will produce better
executions for the Fund.
For the fiscal years ended December 31, 1991, 1992 and 1993, the Fund did
not pay any brokerage commissions for securities transactions.
In no instance are portfolio securities purchased from or sold to Keystone
Management, Keystone, KDI or any of their affiliated persons, as defined in the
1940 Act and rules and regulations issued thereunder.
- --------------------------------------------------------------------------------
STANDARDIZED TOTAL RETURN AND YIELD QUOTATIONS
- --------------------------------------------------------------------------------
Total return quotations for the Fund as they may appear from time to time in
advertisements are calculated by finding the average annual compounded rates of
return over the one, five and ten year periods on a hypothetical $1,000
investment that would equate the initial amount invested to the ending
redeemable value. To the initial investment all dividends and distributions are
added, and all recurring fees charged to all shareholder accounts are deducted.
The ending redeemable value assumes a complete redemption at the end of the one,
five or ten year periods.
The total returns of the Fund for the one, five and ten years ended
December 31, 1993 were 7.15% (including contingent deferred sales charge),
54.15% and 163.42%, respectively. The average annual rates of return for the
five and ten year periods ended December 31, 1993 were 9.04% and 10.17%,
respectively.
Current yield quotations as they may appear from time to time in
advertisements will consist of a quotation based on a 30-day period ended on the
date of the most recent balance sheet of the Portfolio, computed by dividing the
net investment income per share earned during the period by the maximum offering
price per share on the last day of the base period. The current yield for the
30-day period ended December 31, 1993 was 4.53%.
Tax equivalent yield is, in general, the current yield divided by a factor
equal to one minus a stated income tax rate and reflects the yield a taxable
investment would have to achieve in order to equal on an after tax-basis a tax
exempt yield. The tax equivalent yield for the 30-day period ended December 31,
1993 was 6.29%.
Any given yield or total return quotation should not be considered
representative of the Fund's yield or total return for any future period.
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ADDITIONAL INFORMATION
- --------------------------------------------------------------------------------
State Street Bank and Trust Company, 225 Franklin Street, Boston,
Massachusetts 02110, is the custodian ("Custodian") of all securities and cash
of the Fund. The Custodian performs no investment management functions for the
Fund, but, in addition to its custodial services, is responsible for accounting
and related recordkeeping on behalf of the Fund.
KPMG Peat Marwick, One Boston Place, Boston, Massachusetts 02108, Certified
Public Accountants, are the independent auditors for the Fund.
KIRC, located at 101 Main Street, Cambridge, Massachusetts 02142, is a
wholly-owned subsidiary of Keystone, and acts as transfer agent and dividend
disbursing agent for the Fund.
Except as otherwise stated in its prospectus or required by law, the Fund
reserves the right to change the terms of the offer stated in its prospectus
without shareholder approval, including the right to impose or change fees for
services provided.
No dealer, salesman or other person is authorized to give any information
or to make any representation not contained in the Fund's prospectus, this
statement of additional information, or in supplemental sales literature issued
by the Fund or the Principal Underwriter, and no person is entitled to rely on
any information or representation not contained therein.
The Fund's prospectus and this statement of additional information omit
certain information contained in the registration statement filed with the
Securities and Exchange Commission, which may be obtained from the Commission's
principal office in Washington, D.C. upon payment of the fee prescribed by the
Rules and Regulations promulgated by the Commission.
As of January 31, 1994, Merrill Lynch Pierce Fenner & Smith, Attn: Book
Entry, 4800 Deer Lake Dr. E., 3rd Floor, Jacksonville, FL 32246-6484 owned 20%
of the Fund's outstanding shares.
<PAGE>
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APPENDIX
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MUNICIPAL BONDS
Municipal bonds include debt obligations issued by or on behalf of a state,
a territory, or a possession of the United States, the District of Columbia or
any political subdivision, agency or instrumentality thereof (for example,
counties, cities, towns, villages, districts, authorities) to obtain funds for
various public purposes, including the construction of a wide range of public
facilities such as airports, bridges, highways, housing, hospitals, mass
transportation, schools, streets and water and sewer works. Other public
purposes for which municipal bonds may be issued include the refunding of
outstanding obligations, obtaining funds for general operating expenses and
obtaining funds to lend to public or private institutions for the construction
of facilities such as educational, hospital and housing facilities. In addition,
certain types of industrial development bonds have been or may be issued by or
on behalf of public authorities to finance certain privately operated facilities
and certain local facilities for water supply, gas, electricity or sewage or
solid waste disposal. Such obligations are included within the term municipal
bonds if the interest paid thereon qualifies as exempt from federal income tax.
The income of certain types of industrial development bonds used to finance
certain privately operated facilities (qualified "private activity" bonds)
issued after August 7, 1986, while exempt from federal income tax, is includable
for purposes of the calculation of the altnerative minimum tax. Other types of
industrial development bonds, the proceeds of which are used for the
construction, equipment, repair or improvement of privately operated industrial
or commercial facilities, may constitute municipal bonds, although the current
federal tax laws place substantial limitations on the size of such issues.
The two principal classifications of municipal bonds are "general
obligation" and limited obligation or "revenue" bonds. General obligation bonds
are obligations involving the credit of an issuer possessing taxing power and
are payable from the issuer's general unrestricted revenues and not from any
particular fund or revenue source. Their payment may be dependent upon an
appropriation by the issuer's legislative body and may be subject to
quantitative limitations on the issuer's taxing power. The characteristics and
methods of enforcement of general obligation bonds vary according to the law
applicable to the particular issuer. Limited obligation or revenue bonds are
payable only from the revenues derived from a particular facility or class of
facilities or, in some cases, from the proceeds of a special excise or other
specific revenue source, such as the user of the facility. Industrial
development bonds which are municipal bonds are in most cases revenue bonds and
generally are not payable from the unrestricted revenues of the issuer. The
credit quality of industrial development revenue bonds is usually directly
related to the credit standing of the owner or user of the facilities. There
are, of course, variations in the security of municipal bonds, both within a
particular classification and between classifications, depending on numerous
factors.
The yields on municipal bonds are dependent on a variety of factors,
including general money market conditions, the financial condition of the
issuer, general conditions of the municipal bond market, size of a particular
offering, the maturity of the obligation and rating of the issue. The ratings of
Moody's Investors Service, Inc. ("Moody's") and Standard & Poor's Corporation
("S&P"), as described below, represent their opinions as to the quality of the
municipal bonds which they undertake to rate. It should be emphasized, however,
that ratings are general and are not absolute standards of quality.
Consequently, municipal bonds with the same maturity, interest rate and rating
may have different yields while municipal bonds of the same maturity and
interest rate with different ratings may have the same yield. It should also be
noted that the standards of disclosure applicable to and the amount of
information relating to the financial condition of issuers of municipal bonds
are not as extensive as those generally relating to corporations.
Subsequent to its purchase by the Fund, an issue of municipal bonds or other
investment may cease to be rated or its rating may be reduced below the minimum
rating required for purchase by the Fund. Neither event requires the elimination
of such obligation from the Fund's portfolio, but Keystone will consider such an
event in its determination of whether the Fund should continue to hold such
obligation in its portfolio.
The ability of the Fund to achieve its investment objective is dependent
upon the continuing ability of issuers of municipal bonds to meet their
obligations to pay interest and principal when due. Obligations of issuers of
municipal bonds, including municipal bonds issued by them, are subject to the
provisions of bankruptcy, insolvency and other laws affecting the rights and
remedies of creditors, such as the federal Bankruptcy Act, and laws, if any,
which may be enacted by Congress or state legislatures extending the time for
payment of principal or interest, or both, or imposing other constraints upon
enforcement of such obligations. There is also the possibility that as a result
of litigation or other conditions, the power or ability of any one or more
issuers to pay, when due, principal of and interest on its or their municipal
bonds may be materially affected. In addition the market for municipal bonds is
often thin and can be temporarily affected by large purchases and sales
including those by the Fund.
From time to time, proposals have been introduced before Congress for the
purpose of restricting or eliminating the federal income tax exemption for
interest on municipal bonds, and similar proposals may well be introduced in the
future. If such a proposal were enacted, the availability of municipal bonds for
investment by the Fund and the value of the Fund's portfolio could be materially
affected, in which event the Fund would reevaluate its investment objective and
policies and consider changes in the structure of the Fund or dissolution.
DESCRIPTION OF BOND RATINGS
The Tax Reform Act of 1986 made significant changes in the federal tax
status of certain obligations which were previously fully federally tax exempt.
As a result, three categories of such obligations issued after August 7, 1986
now exist: (1) "public purpose" bonds, the income of which remains fully exempt
from federal income tax, (2) qualified "private activity" industrial development
bonds, the income of which, while exempt from federal income tax under section
103 of the Internal Revenue Code of 1954 as amended (Code) is includable in the
calculation of the federal alternative minimum tax, and (3) "private activity"
(private purpose) bonds, the income of which is not exempt from federal income
tax. The Fund will not invest in private activity (private purpose) bonds, and,
except as described under "Other Eligible Securities", will not invest in
qualified "private activity" industrial development bonds.
CORPORATE AND MUNICIPAL BOND RATINGS
S&P CORPORATE AND MUNICIPAL BOND RATINGS
A. MUNICIPAL NOTES
An S&P note rating reflects the liquidity concerns and market access risks
unique to notes. Notes due in 3 years or less will likely receive a note rating.
Notes maturing beyond 3 years will most likely receive a long term debt rating.
The following criteria are used in making that assessment:
a. Amortization schedule (the larger the final maturity relative to other
maturities the more likely it will be treated as a note), and
b. Source of payment (the more dependent the issue is on the market for its
refinancing, the more likely it will be treated as a note).
Note ratings are as follows:
1. SP-1 Very strong or strong capacity to pay principal and interest.
Those issues determined to possess overwhelming safety characteristics will be
given a plus (+) designation.
2. SP-2 Satisfactory capacity to pay principal and interest.
3. SP-3 Speculative capacity to pay principal and interest.
B. TAX EXEMPT DEMAND BONDS
S&P assigns "dual" ratings to all long-term debt issues that have as part of
their provisions a demand or double feature.
The first rating addresses the likelihood of repayment of principal and
interest as due, and the second rating addresses only the demand feature. The
long-term debt rating symbols are used for bonds to denote the long-term
maturity and the commercial paper rating symbols are used to denote the put
option (for example, "AAA/A-1+"). For the newer "demand notes," S&P note rating
symbols, combined with the commercial paper symbols, are used (for example,
"SP-1+/A-1+" ).
C. CORPORATE AND MUNICIPAL BOND RATINGS
An S&P corporate or municipal bond rating is a current assessment of the
creditworthiness of an obligor, including obligors outside the U.S., with
respect to a specific obligation. This assessment may take into consideration
obligors such as guarantors, insurers, or lessees. Ratings of foreign obligors
do not take into account currency exchange and related uncertainties. The
ratings are based on current information furnished by the issuer or obtained by
S&P from other sources it considers reliable.
The ratings are based, in varying degrees, on the following considerations:
a. Likelihood of default - capacity and willingness of the obligor as to
the timely payment of interest and repayment of principal in accordance
with the terms of the obligation;
b. Nature of and provisions of the obligation; and
c. Protection afforded by and relative position of the obligation in the
event of bankruptcy reorganization or other arrangement under the laws
of bankruptcy and other laws affecting creditors' rights.
PLUS (+) OR MINUS (-): To provide more detailed indications of credit
quality, ratings FROM "AA" TO "BBB" may be modified by the addition of a plus or
minus sign to show relative standing within the major rating categories.
A provisional rating is sometimes used by S&P. It assumes the successful
completion of the project being financed by the debt being rated and indicates
that payment of debt service requirements is largely or entirely dependent upon
the successful and timely completion of the project. This rating, however, while
addressing credit quality subsequent to completion of the project, makes no
comment on the likelihood of, or the risk of default upon failure of, such
completion.
Bond ratings are as follows:
1. AAA - Debt rated AAA has the highest rating assigned by S&P. Capacity to
pay interest and repay principal is extremely strong.
2. AA - Debt rated AA has a very strong capacity to pay interest and repay
principal and differs from the higher rated issues only in small degree.
3. A - Debt rated A has a strong capacity to pay interest and repay
principal although it is somewhat more susceptible to the adverse effects of
changes in circumstances and economic conditions than debt in higher rated
categories.
4. BBB - Debt rated BBB is regarded as having an adequate capacity to pay
interest and repay principal. Whereas it normally exhibits adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay interest and repay principal for
debt in this category than in higher rated categories.
MOODY'S CORPORATE AND MUNICIPAL BOND RATINGS
Moody's ratings are as follows:
1. Aaa - Bonds which are rated Aaa are judged to be of the best
quality. They carry the smallest degree of investment risk and are generally
referred to as "gilt-edge". Interest payments are protected by a large or by an
exceptionally stable margin and principal is secure. While the various
protective elements are likely to change, such changes as can be visualized are
most unlikely to impair the fundamentally strong position of such issues.
2. Aa - Bonds which are rated Aa are judged to be of high quality by all
standards. Together with the Aaa group they comprise what are generally known as
high grade bonds. They are rated lower than the best bonds because margins of
protection may not be as large as in Aaa securities or fluctuation of protective
elements may be of greater amplitude or there may be other elements present
which make the long-term risks appear somewhat larger than in Aaa- securities.
3. A - Bonds which are rated A possess many favorable investment attributes
and are to be considered as upper medium grade obligations. Factors giving
security to principal and interest are considered adequate but elements may be
present which suggest a susceptibility to impairment sometime in the future.
4. Baa - Bonds which are rated Baa are considered as medium grade
obligations, i.e., they are neither highly protected nor poorly secured.
Interest payments and principal security appear adequate for the present but
certain protective elements may be lacking or may be characteristically
unreliable over any great length of time. Such bonds lack outstanding investment
characteristics and in fact have speculative characteristics as well.
Moody's applies numerical modifiers, 1, 2 and 3 in each generic rating
classification from Aa through Baa in its corporate bond rating system. The
modifier 1 indicates that the security ranks in the higher end of its generic
rating category; the modifier 2 indicates a mid-range ranking; and the modifier
3 indicates that the issue ranks in the lower end of its generic rating
category.
CON. (---) - Municipal bonds for which the security depends upon the
completion of some act or the fulfillment of some condition are rated
conditionally. These are bonds secured by (a) earnings of projects under
construction, (b) earnings of projects unseasoned in operation experience, (c)
rentals which begin when facilities are completed, or (d) payments to which some
other limiting condition attaches. Parenthetical rating denotes probable credit
stature upon completion of construction or elimination of basis of condition.
Those municipal bonds in the Aa, A, AND Baa groups which Moody's believes
possess the strongest investment attributes are designated by the symbols Aa 1,
A 1, AND Baa 1.
MONEY MARKET INSTRUMENTS
The Fund's investments in commercial paper are limited to those rated A-1 by
S&P, Prime-1 by Moody's, or F-1 by Fitch Investors Service, Inc.("Fitch's")
These ratings and other money market instruments are described as follows:
COMMERCIAL PAPER RATINGS
Commercial paper rated A-1 by S&P has the following characteristics:
Liquidity ratios are adequate to meet cash requirements. The issuer's long-term
senior debt is rated "A" or better, although in some cases "BBB" credits may be
allowed. The issuer has access to at least two additional channels of borrowing.
Basic earnings and cash flow have an upward trend with allowance made for
unusual circumstances. Typically, the issuer's industry is well established and
the issuer has a strong position within the industry.
Commercial paper rated A-2 by S&P has the same characteristics as that rated
A-1 except that the relative degree of safety is not as overwhelming.
Commercial paper rated A-3 has a satisfactory capacity for timely payment.
However, it is somewhat more vulnerable to the adverse effects of changes in
circumstances than obligations rated A-1 or A-2.
The rating Prime-1 is the highest commercial paper rating assigned by
Moody's. Among the factors considered by Moody's in assigning ratings are the
following: (1) evaluation of the management of the issuer; (2) economic
evaluation of the issuer's industry or industries and an appraisal of
speculative-type risks which may be inherent in certain areas; (3) evaluation of
the issuer's products in relation to competition and customer acceptance; (4)
liquidity; (5) amount and quality of long-term debt; (6) trend of earnings over
a period of ten years; (7) financial strength of a parent company and the
relationships which exist with the issuer; and (8) recognition by the management
of obligations which may be present or may arise as a result of public
preparations to meet such obligations. Relative strength or weakness of the
above factors determines how the issuer's commercial paper is rated within
various categories.
Commercial paper rated Prime-2 by Moody's is considered somewhat lower than
the best commercial paper because margins of protection may not be as large or
because fluctuations of protective elements over the near or intermediate term
may be of greater amplitude.
UNITED STATES GOVERNMENT SECURITIES
Securities issued or guaranteed by the United States Government include a
variety of Treasury securities that differ only in their interest rates,
maturities and dates of issuance. Treasury bills have maturities of one year or
less. Treasury notes have maturities of one to ten years and Treasury bonds
generally have maturities of greater than ten years at the date of issuance.
Securities issued or guaranteed by the United States Government or its
agencies or instrumentalities include direct obligations of the United States
Treasury and securities issued or guaranteed by the Federal Housing
Administration, Farmers Home Adminis tration, Export-Import Bank of the United
States, Small Business Administration, Government National Mortgage Association,
General Services Administration, Central Bank for Cooperatives, Federal Home
Loan Banks, Federal Loan Mortgage Corporation, Federal Intermediate Credit
Banks, Federal Land Banks, Maritime Administration, The Tennessee Valley
Authority, District of Columbia Armory Board and Federal National Mortgage
Association.
Some obligations of United States Government agencies and instrumentalities,
such as Treasury bills and Government National Mortgage Association pass-through
certificates, are supported by the full faith and credit of the United States;
others, such as securities of Federal Home Loan Banks, by the right of the
issuer to borrow from the Treasury; still others, such as bonds issued by the
Federal National Mortgage Association, a private corporation, are supported only
by the credit of the instrumentality. Because the United States Government is
not obligated by law to provide support to an instrumentality it sponsors, the
Fund will invest in the securities issued by such an instrumentality only when
Keystone determines that the credit risk with respect to the instrumentality
does not make its securities unsuitable investments. United States Government
securities will not include international agencies or instrumentalities in which
the United States Government, its agencies or instrumentalities participate,
such as the World Bank, the Asian Development Bank or the InterAmerican
Development Bank, or issues insured by the Federal Deposit Insurance
Corporation.
CERTIFICATES OF DEPOSITS
Certificates of deposit are receipts issued by a bank in exchange for the
deposit of funds. The issuer agrees to pay the amount deposited plus interest to
the bearer of the receipt on the date specified on the certificate. The
certificate usually can be traded in the secondary market prior to maturity.
Certificates of deposit will be limited to U.S. dollar-denominated
certificates of United States banks, including their branches abroad) and of
U.S. branches of foreign banks, which are members of the Federal Reserve System
or the Federal Deposit Insurance Corporation, and have at least $1 billion in
deposits as of the date of their most recently published financial statements.
The Fund will not acquire time deposits or obligations issued by the
International Bank for Reconstruction and Development, the Asian Development
Bank or the Inter-American Development Bank. Additionally, the Fund does not
currently intend to purchase foreign securities (except to the extent that
certificates of deposit of foreign branches of U.S. banks may be deemed foreign
securities) or purchase certificates of deposit, bankers' acceptances or other
similar obligations issued by foreign banks.
BANKERS' ACCEPTANCES
Bankers' acceptances typically arise from short-term credit arrangements
designed to enable businesses to obtain funds to finance commercial
transactions. Generally, an acceptance is a time draft drawn on a bank by an
exporter or an importer to obtain a stated amount of funds to pay for specific
merchandise. The draft is then "accepted" by the bank that, in effect,
unconditionally guarantees to pay the face value of the instrument on its
maturity date. The acceptance may then be held by the accepting bank as an
earning asset or it may be sold in the secondary market at the going rate of
discount for a specific maturity. Although maturities for acceptances can be as
long as 270 days, most acceptances have maturities of six months or less.
Bankers' acceptances acquired by the Fund must have been accepted by U.S.
commercial banks, including foreign branches of U.S. commercial banks, having
total deposits at the time of purchase in excess of $1 billion and must be
payable in U.S. dollars.
OPTIONS TRANSACTIONS
The Fund may enter into options transactions. Any premium paid by the Fund
in connection with an option transaction may be forfeited if the option expires
unexercised.
WRITING COVERED OPTIONS. The Fund writes only covered options. Options
written by the Fund will normally have expiration dates of not more than nine
months from the date written. The exercise price of the options may be below,
equal to, or above the current market values of the underlying securities at the
times the options are written.
Unless the option has been exercised, the Fund may close out an option it
has written by effecting a closing purchase transaction, whereby it purchases an
option covering the same underlying security and having the same exercise price
and expiration date ("of the same series") as the one it has written. If the
Fund desires to sell a particular security on which it has written a call
option, it will effect a closing purchase transaction prior to or concurrently
with the sale of the security. If the Fund is able to enter into a closing
purchase transaction, the Fund will realize a profit (or loss) from such
transaction if the cost of such transaction is less (or more) than the premium
received from the writing of the option.
An option position may be closed out only in a secondary market for an
option of the same series. Although the Fund will generally write only those
options for which there appears to be an active secondary market, there is no
assurance that a liquid secondary market will exist for any particular option at
any particular time, and for some options no secondary market may exist. In such
event able to effect a closing purchase transaction, it will not be able to sell
the underlying securities until the option expires or it delivers the underlying
securities upon exercise.
Because the Fund intends to qualify as a regulated investment company under
the Internal Revenue Code, the extent to which the Fund may write covered call
options and enter into so-called "straddle" transactions involving put and call
options may be limited.
Many options are traded on registered securities exchanges. Options traded
on such exchanges are issued by the Options Clearing Corporation (OCC), a
clearing corporation which assumes responsibility for the completion of options
transactions.
PURCHASING PUT AND CALL OPTIONS. The Fund can close out a put option it has
purchased by effecting a closing sale transaction; for example, the Fund may
close out a put option it has purchased by selling a put option. If, however, a
secondary market does not exist at a time the Fund wishes to effect a closing
sale transaction, the Fund will have to exercise the option to realize any
profit. In addition, in a transaction in which the Fund does not own the
security underlying a put option it has purchased, the Fund would be required,
in the absence of a secondary market, to purchase the underlying security before
it could exercise the option. In each such instance, the Fund would incur
additional transaction costs.
The Fund may purchase call options for the purpose of offsetting previously
written call options of the same series. The Fund also may purchase call options
to fix the interest rates of obligations held by it.
The Fund will not purchase a put option if, as a result of such purchase,
more than 10% of its total assets would be invested in premiums for such
options. The Fund's ability to purchase put and call options may be limited by
the Internal Revenue Code's requirements for qualification as a regulated
investment company.
OPTION WRITING AND RELATED RISKS
The Fund may write covered call and put options. A call option gives the
purchaser of the option the right to buy, and the writer the obligation to sell,
the underlying security at the exercise price during the option period.
Conversely, a put option gives the purchaser the right to sell, and the writer
the obligation to buy, the underlying security at the exercise price during the
option period.
So long as the obligation of the writer continues, the writer may be
assigned an exercise notice by the broker-dealer through whom the option was
sold. The exercise notice would require the writer to deliver, in the case of a
call, or take delivery of, in the case of a put, the underlying security against
payment of the exercise price. This obligation terminates upon expiration of the
option, or at such earlier time as the writer effects a closing purchase
transaction by purchasing an option of the same series as the one previously
sold. Once an option has been exercised, the writer may not execute a closing
purchase transaction. For options traded on national securities exchanges
(Exchanges), to secure the obligation to deliver the underlying security in the
case of a call option, the writer of the option is required to deposit in escrow
the underlying security or other assets in accordance with the rules of the OCC,
an institution created to interpose itself between buyers and sellers of
options. Technically, the OCC assumes the order side of every purchase and sale
transaction on an Exchange and, by doing so, gives its guarantee to the
transaction.
The principal reason for writing options on a securities portfolio is to
attempt to realize, through the receipt of premiums, a greater return than would
be realized on the underlying securities alone. In return for the premium, the
covered call option writer has given up the opportunity for profit from a price
increase in the underlying security above the exercise price so long as the
option remains open, but retains the risk of loss should the price of the
security decline. Conversely, the put option writer gains a profit, in the form
of a premium, so long as the price of the underlying security remains above the
exercise price, but assumes an obligation to purchase the underlying security
from the buyer of the put option at the exercise price, even though the price of
the security may fall below the exercise price, at any time during the option
period. If an option expires, the writer realizes a gain in the amount of the
premium. Such a gain may, in the case of a covered call option, be offset by a
decline in the market value of the underlying security during the option period.
If a call option is exercised, the writer realizes a gain or loss from the sale
of the underlying security. If a put option is exercised, the writer must
fulfill his obligation to purchase the underlying security at the exercise
price, which will usually exceed the then market value of the underlying
security. In addition, the premium paid for the put effectively increases the
cost of the underlying security, thus reducing the yield otherwise available
from such securities.
Because the Fund can write only covered options, it may at times be unable
to write additional options unless it sells a portion of its portfolio holdings
to obtain new securities against which it can write options. This may result in
higher portfolio turnover and correspondingly greater brokerage commissions and
other transaction costs.
To the extent that a secondary market is available, the covered option
writer may close out options it has written prior to the assignment of an
exercise notice by purchasing, in a closing purchase transaction, an option of
the same series as the option previously written. If the cost of such a closing
purchase plus transaction costs is greater than the premium received upon
writing the original option, the writer will incur a loss in the transaction.
OPTIONS TRADING MARKETS
Options which the Fund will trade are generally listed on national
securities exchanges. Exchanges on which such options currently are traded are
the Chicago Board Options Exchange and the New York, American, Pacific, and
Philadelphia Stock Exchanges (Exchanges). Options on some securities may not be
listed on any Exchange but traded in the over the counter market. Options traded
in the over the counter market involve the additional risk that securities
dealers participating in such transactions would fail to meet their obligations
to the Fund. The use of options traded in the over the counter market may be
subject to limitations imposed by certain state securities authorities. In
addition to the limits on its use of options discussed herein, the Fund is
subject to the investment restrictions described in the prospectus and statement
of additional information.
The staff of the Securities and Exchange Commission (Commission) currently
is of the view that the premiums which the Fund pays for the purchase of
unlisted options, and the value of securities used to cover unlisted options
written by the Fund are considered to be invested in illiquid securities or
assets for the purpose of calculating whether the Fund is in compliance with its
fundamental investment restriction prohibiting it from investing more than 10%
of its total assets (taken at current value) in any combination of illiquid
assets and securities. The Fund intends to request that the Commission staff
reconsider its current view. It is the intention of the Fund to comply with the
staff's current position and the outcome of such reconsideration.
SPECIAL CONSIDERATIONS APPLICABLE TO OPTIONS
ON TREASURY BONDS AND NOTES. Because trading interest in U.S. Treasury bonds
and notes tends to center on most recently auctioned issues, new series of
options with expirations to replace expiring options on particular issues will
not be introduced indefinitely. Instead, the expirations introduced at the
commencement of options trading on a particular issue will be allowed to run
their course, with the possible addition of a limited number of new expirations
as the original ones expire. Options trading on each series of bonds or notes
will thus be phased out as new options are listed on the more recent issues, and
a full range of expiration dates will not ordinarily be available for every
series on which options are traded.
ON TREASURY BILLS. Because the deliverable U.S. Treasury bill changes from
week to week, writers of U.S. Treasury bills call options cannot provide in
advance for their potential exercise settlement obligations by acquiring and
holding the underlying security. However, if the Fund holds a long position in
U.S. Treasury bills with a principal amount corresponding to the option contract
size, the Fund may be hedged from a risk standpoint. In addition, the Fund will
maintain in a segregated account with its Custodian able in the event of an
assignment of an exercise notice to ensure that it can meet its open option
obligations.
ON GNMA CERTIFICATES. Options on GNMA certificates are not currently traded
on any Exchange. However, the Fund may purchase and write such options in the
over the counter market, or should they commence trading, on any Exchange.
Since the remaining principal balance of GNMA certificates declines each
month as a result of mortgage payments, the Fund, as a writer of a covered GNMA
call holding GNMA certificates as "cover" to satisfy its delivery obligation in
the event of assignment of an exercise notice, may find that its GNMA
certificates no longer have a sufficient remaining principal balance for this
purpose. Should this occur, the Fund will enter into a closing purchase
transaction or will purchase additional GNMA certificates from the same pool (if
obtainable) or replacement GNMA certificates in the cash market in order to
remain covered.
A GNMA certificate held by the Fund to cover an option position in any but
the nearest expiration month may cease to present cover for the option in the
event of a decline in the GNMA coupon rate at which new pools are originated
under the FHA/VA loan ceiling in effect at any given time. Should this occur,
the Fund will no longer be covered, and the Fund will either enter into a
closing purchase transaction or replace the GNMA certificate with a certificate
which represents cover. When the Fund closes its position or replaces the GNMA
certificate, it may realize an unanticipated loss and incur transaction costs.
RISKS PERTAINING TO THE SECONDARY MARKET. An option position may be closed
out only in a secondary market for an option of the same series. Although the
Fund will generally purchase or write only those options for which there appears
to be an active secondary market, there is no assurance that a liquid secondary
market will exist for any particular option at any particular time, and for some
options no secondary market may exist. In such event, it might not be possible
to effect closing transactions in particular options, with the result that the
Fund would have to exercise its options in order to realize any profit and might
incur transaction costs in connection therewith. If the Fund as a covered call
option writer is unable to effect a closing purchase transaction in a secondary
market, it will not be able to sell the underlying security until the option
expires or it delivers the underlying security upon exercise.
Reasons for the absence of a liquid secondary market include the following
(i) insufficient trading interest in certain options; (ii) restrictions imposed
on transactions; (iii) trading halts, suspensions or other restrictions imposed
with respect to particular classes or series of options or underlying
securities;(iv) interruption of the normal operations on an Exchange or by a
broker; (v) inadequacy of the facilities of an Exchange, the OCC or a broker to
handle current trading volume; or (vi) a decision by one or more Exchanges or a
broker to discontinue the trading of options (or a particular class or series of
options), in which event the secondary market in that class or series of options
would cease to exist, although outstanding options that had been issued as a
result of trades would generally continue to be exercisable in accordance with
their terms.
The hours of trading for options on U.S. government securities may not
conform to the hours during which the underlying securities are traded. To the
extent that the option markets close before the markets for the underlying
securities, significant price and rate movements can take place in the
underlying markets that cannot be reflected in the option markets.
FUTURES CONTRACTS AND RELATED OPTIONS TRANSACTIONS
The Fund intends to enter into currency and other financial futures
contracts as a hedge against changes in prevailing levels of interest or
currency exchange rates to seek relative stability of principal and to establish
more definitely the effective return on securities held or intended to be
acquired by the Fund or as a hedge against changes in the prices of securities
or currencies held by the Fund or to be acquired by the Fund. The Fund's hedging
may include sales of futures as an offset against the effect of expected
increases in interest or currency exchange rates or securities prices and
purchases of futures as an offset against the effect of expected declines in
interest or currency exchange rates.
For example, when the Fund anticipates a significant market or market sector
advance, it will purchase a stock index futures contract as a hedge against not
participating in such advance at a time when the Fund is not fully invested. The
purchase of a futures contract serves as a temporary substitute for the purchase
of individual securities which may then be purchased in an orderly fashion. As
such purchases are made, an equivalent amount of index based futures contracts
would be terminated by offsetting sales. In contrast, the Fund would sell stock
index futures contracts in anticipation of or in a general market or market
sector decline that may adversely affect the market value of the Fund's
portfolio. To the extent that the Fund's portfolio changes in value in
correlation with a given index, the sale of futures contracts on that index
would substantially reduce the risk to the portfolio of a market decline or
change in interest rates, and, by so doing, provide an alternative to the
liquidation of the Fund's securities positions and the resulting transaction
costs.
The Fund intends to engage in options transactions which are related to
commodity futures contracts for hedging purposes and in connection with the
hedging strategies described above.
Although techniques other than sales and purchases of futures contracts and
related options transactions could be used to reduce the Fund's exposure to
interest rate and/or market fluctuations, the Fund may be able to hedge its
exposure more effectively and perhaps at a lower cost through using futures
contracts and related options transactions. While the Fund does not intend to
take delivery of the instruments underlying futures contracts it holds, the Fund
does not intend to engage in such futures contracts for speculation.
FUTURES CONTRACTS
Futures contracts are transactions in the commodities markets rather than in
the securities markets. A futures contract creates an obligation by the seller
to deliver to the buyer the commodity specified in the contract at a specified
future time for a specified price. The futures contract creates an obligation by
the buyer to accept delivery from the seller of the commodity specified at the
specified future time for the specified price. In contrast, a spot transaction
creates an immediate obligation for the seller to deliver and the buyer to
accept delivery of and pay for an identified commodity. In general, futures
contracts involve transactions in fungible goods such as wheat, coffee and
soybeans. However, in the last decade an increasing number of futures contracts
have been developed which specify currencies, financial instruments or
financially based indexes as the underlying commodity.
U.S. futures contracts are traded only on national futures exchanges and are
standardized as to maturity date and underlying financial instrument. The
principal financial futures exchanges in the United States are The Board of
Trade of the City of Chicago, the Chicago Mercantile Exchange, the International
Monetary Market (a division of the Chicago Mercantile Exchange), the New York
Futures Exchange and the Kansas City Board of Trade. Each exchange guarantees
performance under contract provisions through a clearing corporation, a
nonprofit organization managed by the exchange membership, which is also
responsible for handling daily accounting of deposits or withdrawals of margin.
A futures commission merchant (Broker) effects each transaction in connection
with futures contracts for a commission. Futures exchanges and trading are
regulated under the Commodity Exchange Act by the Commodity Futures Trading
Commission (CFTC) and National Futures Association (NFA).
INTEREST RATE FUTURES CONTRACTS
The sale of an interest rate futures contract creates an obligation by the
Fund, as seller, to deliver the type of financial instrument specified in the
contract at a specified future time for a specified price. The purchase of an
interest rate futures contract creates an obligation by the Fund, as purchaser,
to accept delivery of the type of financial instrument specified at a specified
future time for a specified price. The specific securities delivered or
accepted, respectively, at settlement date, are not determined until at or near
that date. The determination is in accordance with the rules of the exchange on
which the futures contract sale or purchase was made.
Currently interest rate futures contracts can be purchased or sold on 90-day
U.S. Treasury bills, U.S. Treasury bonds, U.S. Treasury notes with maturities
between 6 1/2 and 10 years, Government National Mortgage Association (GNMA)
certificates, 90-day domestic bank certificates of deposit, 90-day commercial
paper, and 90-day Eurodollar certificates of deposit. It is expected that
futures contracts trading in additional financial instruments will be
authorized. The standard contract size is $100,000 for futures contracts in U.S.
Treasury bonds, U.S. Treasury notes and GNMA certificates, and $1,000,000 for
the other designated contracts. While U.S. Treasury bonds, U.S. Treasury bills
and U.S. Treasury notes are backed by the full faith and credit of the U.S.
government and GNMA certificates are guaranteed by a U.S. government agency, the
futures contracts in U.S. government securities are not obligations of the U.S.
Treasury.
INDEX BASED FUTURES CONTRACTS
It is expected that bond index and other financially based index futures
contracts will be developed in the future. It is anticipated that such index
based futures contracts will be structured in the same way as stock index
futures contracts but will be measured by changes in interest rates, related
indexes or other measures, such as the consumer price index. In the event that
such futures contracts are developed the Fund will sell interest rate index and
other index based futures contracts to hedge against changes which are expected
to affect the Fund's portfolio.
The purchase or sale of a futures contract differs from the purchase or sale
of a security, in that no price or premium is paid or received. Instead, to
initiate trading an amount of cash, cash equivalents, money market instruments,
or U.S. Treasury bills equal to approximately 1 1/2% (up to 5%) of the contract
amount must be deposited by the Fund with the Broker. This amount is known as
initial margin. The nature of initial margin in futures transactions is
different from that of margin in security transactions. Futures contract margin
does not involve the borrowing of funds by the customer to finance the
transactions. Rather, the initial margin is in the nature of a performance bond
or good faith deposit on the contract which is returned to the Fund upon
termination of the futures contract assuming all contractual obligations have
been satisfied. The margin required for a particular futures contract is set by
the exchange on which the contract is traded, and may be significantly modified
from time to time by the exchange during the term of the contract.
Subsequent payments, called variation margin, to the Broker and from the
Broker, are made on a daily basis as the value of the underlying instrument or
index fluctuates making the long and short positions in the futures contract
more or less valuable, a process known as mark-to-market. For example, when the
Fund has purchased a futures contract and the price of the underlying financial
instrument or index has risen, that position will have increased in value and
the Fund will receive from the Broker a variation margin payment equal to that
increase in value. Conversely, where the Fund has purchased a futures contract
and the price of the underlying financial instrument or index has declined, the
position would be less valuable and the Fund would be required to make a
variation margin payment to the Broker. At any time prior to expiration of the
futures contract, the Fund may elect to close the position. A final
determination of variation margin is then made, additional cash is required to
be paid to or released by the Broker, and the Fund realizes a loss or gain.
The Fund intends to enter into arrangements with its custodian and with
Brokers to enable its initial margin and any variation margin to be held in a
segregated account by its custodian on behalf of the Broker.
Although interest rate futures contracts by their terms call for actual
delivery or acceptance of financial instruments, and index based futures
contracts call for the delivery of cash equal to the difference between the
closing value of the index on the expiration date of the contract and the price
at which the futures contract is originally made, in most cases such futures
contracts are closed out before the settlement date without the making or taking
of delivery. Closing out a futures contract sale is effected by an offsetting
transaction in which the Fund enters into a futures contract purchase for the
same aggregate amount of the specific type of financial instrument or index and
same delivery date. If the price in the sale exceeds the price in the offsetting
purchase, the Fund is paid the difference and thus realizes a gain. If the
offsetting purchase price exceeds the sale price, the Fund pays the difference
and realizes a loss. Similarly, the closing out of a futures contract purchase
is ef- fected by an offsetting transaction in which the Fund enters into a
futures contract sale. If the offsetting sale price exceeds the purchase price,
the Fund realizes a gain. If the purchase price exceeds the offsetting sale
price the Fund realizes a loss. The amount of the Fund's gain or loss on any
transaction is reduced or increased, respectively, by the amount of any
transaction costs incurred by the Fund.
As an example of an offsetting transaction, the contractual obligations
arising from the sale of one contract of September U.S. Treasury bills on an
exchange may be fulfilled at any time before delivery of the contract is
required (i.e., on a specified date in September, the "delivery month") by the
purchase of one contract of September U.S. Treasury bills on the same exchange.
In such instance the difference between the price at which the futures contract
was sold and the price paid for the offsetting purchase after allowance for
transaction costs represents the profit or loss to the Fund.
There can be no assurance, however, that the Fund will be able to enter into
an offsetting transaction with respect to a particular contract at a particular
time. If the Fund is not able to enter into an offsetting transaction, the Fund
will continue to be required to maintain the margin deposits on the contract and
to complete the contract according to its terms.
OPTIONS ON CURRENCY AND OTHER FINANCIAL FUTURES
The Fund intends to purchase call and put options on currency and other
financial futures contracts and sell such options to terminate an existing
position. Options on currency and other financial futures contracts are similar
to options on stocks except that an option on a currency or other financial
futures contract gives the purchaser the right, in return for the premium paid,
to assume a position in a futures contract (a long position if the option is a
call and a short position if the option is a put) rather than to purchase or
sell stock, currency or other financial instruments at a specified exercise
price at any time during the period of the option. Upon exercise of the option,
the delivery of the futures position by the writer of the option to the holder
of the option will be accompanied by delivery of the accumulated balance in the
writer's futures margin account. This amount represents the amount by which the
market price of the futures contract at exercise exceeds, in the case of a call,
or is less than, in the case of a put, the exercise price of the option on the
futures contract. If an option is exercised the last trading day prior to the
expiration date of the option, the settlement will be made entirely in cash
equal to the difference between the exercise price of the option and value of
the futures contract.
The Fund intends to use options on currency and other financial futures
contracts in connection with hedging strategies. In the future the Fund may use
such options for other purposes.
PURCHASE OF PUT OPTIONS ON FUTURES CONTRACTS
The purchase of protective put options on a currency or other financial
futures contract is analagous to the purchase of protective puts on individual
stocks, where an absolute level of protection is sought below which no
additional economic loss would be incurred by the Fund. Put options may be
purchased to hedge a portfolio of stocks or debt instruments or a position in
the futures contract upon which the put option is based.
PURCHASE OF CALL OPTIONS ON FUTURES CONTRACTS
The purchase of a call option on a currency or other financial futures
contract represents a means of obtaining temporary exposure to market
appreciation at limited risk. It is analogous to the purchase of a call option
on an individual stock which can be used as a substitute for a position in the
stock itself. Depending on the pricing of the option compared to either the
futures contract upon which it is based, or upon the price of the underlying
financial instrument or index itself, the purchase of a call option may be less
risky than the ownership of the interest rate or index based futures contract or
the underlying securities. Call options on currency and other financial futures
contracts may be purchased to hedge against an interest rate increase or a
market advance when the Fund is not fully invested.
USE OF NEW INVESTMENT TECHNIQUES INVOLVING COMMODITY FUTURES CONTRACTS
OR RELATED OPTIONS
The Fund may employ new investment techniques involving currency and other
financial futures contracts and related options. The Fund intends to take
advantage of new techniques in these areas which may be developed from time to
time and which are consistent with the Fund's investment objective. The Fund
believes that no additional techniques have been identified for employment by
the Fund in the foreseeable future other than those described above.
LIMITATIONS ON PURCHASE AND SALE OF FUTURES CONTRACTS AND RELATED
OPTIONS ON SUCH FUTURES CONTRACTS
The Fund will not enter into a futures contract if, as a result thereof,
more than 5% of the Fund's total assets (taken at market value at the time of
entering into the contract) would be committed to margin deposits on such
futures contracts.
The Fund intends that its futures contracts and related options transactions
will be entered into for traditional hedging purposes. That is, futures
contracts will be sold to protect against a decline in the price of securities
that the Fund owns or futures contracts will be purchased to protect the Fund
against an increase in the price of securities it intends to purchase. The Fund
does not intend to enter into futures contracts for speculation.
In instances involving the purchase of futures contracts by the Fund, an
amount of cash and cash equivalents equal to the market value of the futures
contracts will be deposited in a segregated account with the Fund's Custodian
and/or in a margin account with a Broker to collateralize the position and
thereby insure that the use of such futures is unleveraged.
FEDERAL INCOME TAX TREATMENT
For federal income tax purposes, the Fund is required to recognize as income
for each taxable year its net unrealized gains and losses on futures contracts
as of the end of the year as well as those actually realized during the year.
Any gain or loss recognized with respect to a futures contract is considered to
be 60% long term and 40% short term, without regard to the holding period of the
contract. In the case of a futures transaction classified as a "mixed straddle,"
the recognition of losses may be deferred to a later taxable year. The federal
income tax treatment of gains or losses from transactions in options on futures
is unclear.
In order for the Fund to continue to qualify for federal income tax
treatment as a regulated investment company, at least 90% of its gross income
for a taxable year must be derived from qualifying income. Any net gain realized
from the closing out of futures contracts, for purposes of the 90% requirement,
will be qualifying income. In addition, gains realized on the sale or other
disposition of securities held for less than three months must be limited to
less than 30% of the Fund's annual gross income. The 1986 Tax Act added a
provision which effectively treats both positions in certain hedging
transactions as a single transaction for the purpose of the 30% requirement. The
provision provides that, in the case of any "designated hedge," increases and
decreases in the value of positions of the hedge are to be netted for the
purposes of the 30% requirement. However, in certain situations, in order to
avoid realizing a gain within a three month period, the Fund may be required to
defer the closing out of a contract beyond the time when it would otherwise be
advantageous to do so.
RISKS OF FUTURES CONTRACTS
Currency and other financial futures contracts prices are volatile and are
influenced, among other things, by changes in stock prices, market conditions,
prevailing interest rates and anticipation of future stock prices, market
movements or interest rate changes, all of which in turn are affected by
economic conditions, such as government fiscal and monetary policies and
actions, and national and international political and economic events.
At best, the correlation between changes in prices of futures contracts and
of the securities being hedged can be only approximate. The degree of
imperfection of correlation depends upon circumstances, such as variations in
speculative market demand for futures contracts and for securities, including
technical influences in futures contracts trading; differences between the
securities being hedged and the financial instruments and indexes underlying the
standard futures contracts available for trading, in such respects as interest
rate levels, maturities and creditworthiness of issuers, or identities of
securities comprising the index and those in the Fund's portfolio. A decision of
whether, when and how to hedge involves the exercise of skill and judgment, and
even a well-conceived hedge may be unsuccessful to some degree because of market
behavior or unexpected interest rate trends.
Because of the low margin deposits required, futures trading involves an
extremely high degree of leverage. As a result, a relatively small price
movement in a futures contract may result in immediate and substantial loss, as
well as gain, to the investor. For example, if at the time of purchase, 10% of
the value of the futures contract is deposited as margin, a 10% decrease in the
value of the futures contract would result in a total loss of the margin
deposit, before any deduction for the transaction costs, if the account were
then closed out, and a 15% decrease would result in a loss equal to 150% of the
original margin deposit. Thus, a purchase or sale of a futures contract may
result in losses in excess of the amount invested in the futures contract.
However, the Fund would presumably have sustained comparable losses if, instead
of entering into the futures contract, it had invested in the underlying
financial instrument. Furthermore, in order to be certain that the Fund has
sufficient assets to satisfy its obligations under a futures contract, the Fund
will establish a segregated account in connection with its futures contracts
which will hold cash or cash equivalents equal in value to the current value of
the underlying instruments or indices less the margins on deposit.
Most U.S. futures exchanges limit the amount of fluctuation permitted in
futures contract prices during a single trading day. The daily limit establishes
the maximum amount that the price of a futures contract may vary either up or
down from the previous day's settlement price at the end of a trading session.
Once the daily limit has been reached in a particular type of contract, no
trades may be made on that day at a price beyond that limit. The daily limit
governs only price movement during a particular trading day and therefore does
not limit potential losses because the limit may prevent the liquidation of
unfavorable positions. Futures contract prices have occasionally moved to the
daily limit for several consecutive trading days with little or no trading,
thereby preventing prompt liquidation of futures positions and subjecting some
futures traders to substantial losses.
RISKS OF OPTIONS ON FUTURES CONTRACTS
In addition to the risks described above for currency and other financial
futures contracts, there are several special risks relating to options on
futures contracts. The ability to establish and close out positions on such
options will be subject to the development and maintenance of a liquid secondary
market. There is no assurance that a liquid secondary market will exist for any
particular contract or at any particular time. The Fund will not purchase
options on any futures contract unless and until it believes that the market for
such options has developed sufficiently that the risks in connection with such
options are not greater than the risks in connection with the futures contracts.
Compared to the use of futures contracts, the purchase of options on such
futures involves less potential risk to the Fund because the maximum amount at
risk is the premium paid for the options (plus transaction costs). However,
there may be circumstances when the use of an option on a futures contract would
result in a loss to the Fund, even though the use of a futures contract would
not, such as when there is no movement in the level of the futures contract.
FOREIGN CURRENCY TRANSACTIONS
The Fund may invest in securities denominated in foreign currencies, and the
Fund temporarily may hold funds in foreign currencies. Thus, the Fund's share
value will be affected by changes in exchange rates.
FORWARD CURRENCY CONTRACTS
As one way of managing exchange rate risk, the Fund may engage in forward
currency exchange contracts (agreements to purchase or sell currencies at a
specified price and date). Under the contract, the exchange rate for the
transaction (the amount of currency the Fund will deliver or receive when the
contract is completed) is fixed when the Fund enters into the contract. The Fund
usually will enter into these contracts to stabilize the U.S. dollar value of a
security it has agreed to buy or sell. The Fund also may use these contracts to
hedge the U.S. dollar value of a security it already owns, particularly if the
Fund expects a decrease in the value of the currency in which the foreign
security is denominated. Although the Fund will attempt to benefit from using
forward contracts, the success of its hedging strategy will depend on Keystone's
ability to predict accurately the future exchange rates between foreign
currencies and the U.S. dollar. The value of the Fund's investments denominated
in foreign currencies will depend on the relative strength of those currencies
and the U.S. dollar, and the Fund may be affected favorably or unfavorably by
changes in the exchange rate or exchange control regulations between foreign
currencies and the dollar. Changes in foreign currency exchange rates also may
affect the value of dividends and interest earned, gains and losses realized on
the sale of securities and net investment income and gains, if any, to be
distributed to shareholders by the Fund.
CURRENCY FUTURES CONTRACTS
Currency futures contracts are bilateral agreements under which two parties
agree to take or make delivery of a specified amount of a currency at a
specified future time for a specified price. Trading of currency futures
contracts in the United States is regulated under the Commodity Exchange Act by
the Commodity Futures Trading Commission (CFTC) and National Futures Association
(NFA). Currently the only national futures exchange on which currency futures
are traded is the International Monetary Market of the Chicago Mercantile
Exchange. Foreign currency futures trading is conducted in the same manner and
subject to the same regulations as trading in interest rate and index based
futures. The Fund intends to only engage in currency futures contracts for
hedging purposes, and not for speculation. The Fund may engage in currency
futures contracts for other purposes if authorized to do so by the Board. The
hedging strategies which will be used by the Fund in connection with foreign
currency futures contracts are similar to those described above for forward
foreign currency exchange contracts.
Currently currency futures contracts for the British Pound Sterling,
Canadian Dollar, Dutch Guilder, Deutsche Mark, Japanese Yen, Mexican Peso, Swiss
Franc and French Franc can be purchased or sold for U.S. dollars through the
International Monetary Market. It is expected that futures contracts trading in
additional currencies will be authorized. The standard contract sizes are
L125,000 for the Pound, 125,000 for the Guilder, Mark and Swiss Francs,
C$100,000 for the Canadian Dollar, Y12,500,000 for the Yen, and 1,000,000 for
the Peso. In contrast to Forward Currency Exchange Contracts which can be traded
at any time, only four value dates per year are available, the third Wednesday
of March, June, September and December.
FOREIGN CURRENCY OPTIONS TRANSACTIONS
Foreign currency options (as opposed to futures) are traded in a variety of
currencies in both the United States and Europe. On the Philadelphia Stock
Exchange, for example, contracts for half the size of the corresponding futures
contracts on the Chicago Board Options Exchange are traded with up to nine
months maturity in marks, sterling, yen, Swiss francs and Canadian dollars.
Options can be exercised at any time during the contract life and require a
deposit subject to normal margin requirements. Since a futures contract must be
exercised, the Fund must continually make up the margin balance. As a result, a
wrong price move could result in the Fund losing more than the original
investment as it cannot walk away from the futures contract as it can an option
contract.
The Fund will purchase call and put options and sell such options to
terminate an existing position. Options on foreign currency are similar to
options on stocks except that an option on an interest rate and/or index based
futures contract gives the purchaser the right, in return for the premium paid,
to purchase or sell foreign currency, rather than to purchase or sell stock, at
a specified exercise price at any time during the period of the option.
The Fund intends to use foreign currency option transactions in connection
with hedging strategies.
PURCHASE OF PUT OPTIONS ON FOREIGN CURRENCIES
The purchase of protective put options on a foreign currency is analagous to
the purchase of protective puts on individual stocks, where an absolute level of
protection is sought below which no additional economic loss would be incurred
by the Fund. Put options may be purchased to hedge a portfolio of foreign stocks
or foreign debt instruments or a position in the foreign currency upon which the
put option is based.
PURCHASE OF CALL OPTIONS ON FOREIGN CURRENCIES
The purchase of a call option on foreign currency represents a means of
obtaining temporary exposure to market appreciation at limited risk. It is
analogous to the purchase of a call option on an individual stock which can be
used as a substitute for a position in the stock itself. Depending on the
pricing of the option compared to either the foreign currency upon which it is
based, or upon the price of the foreign stock or foreign debt instruments, the
purchase of a call option may be less risky than the ownership of the foreign
currency or the foreign securities. The Fund would purchase a call option on a
foreign currency to hedge against an increase in the foreign currency or a
foreign market advance when the Fund is not fully invested.
The Fund may employ new investment techniques involving forward foreign
currency exchange contracts, foreign currency futures contracts and options on
foreign currencies in order to take advantage of new techniques in these areas
which may be developed from time to time and which are consistent with the
Fund's investment objective. The Fund believes that no additional techniques
have been identified for employment by the Fund in the foreseeable future other
than those described above.
CURRENCY TRADING RISKS
Currency exchange trading may involve significant risks. The four major
types of risk the Fund faces are exchange rate risk, interest rate risk, credit
risk and country risk.
EXCHANGE RATE RISK
Exchange rate risk results from the movement up and down of foreign currency
values in response to shifting market supply and demand. When the Fund buys or
sells a foreign currency, an exposure called an open position is created. Until
the time that position can be "covered" by selling or buying an equivalent
amount of the same currency, the Fund is exposed to the risk that the exchange
rate might move against it. Since exchange rate changes can readily move in one
direction, a position carried overnight or over a number of days involves
greater risk than one carried a few minutes or hours. Techniques such as foreign
currency forward and futures contracts and options on foreign currency are
intended to be used by the Fund to reduce exchange rate risk.
MATURITY GAPS AND INTEREST RATE RISK
Interest rate risk arises whenever there are mismatches or gaps in the
maturity structure of the Fund's foreign exchange currency holdings, which is
the total of its outstanding spot and forward or futures contracts.
Foreign currency transactions often involve borrowing short term and lending
longer term to benefit from the normal tendency of interest rates to be higher
for longer maturities. However in foreign exchange trading, while the maturity
pattern of interest rates for one currency is important, it is the differential
between interest rates for two currencies that is decisive.
CREDIT RISK
Whenever the Fund enters into a foreign exchange contract, it faces a risk,
however small, that the counterparty will not perform under the contract. As a
result there is a credit risk, although no extension of "credit" is intended. To
limit credit risk, the Fund intends to evaluate the creditworthiness of each
other party. The Fund does not intend to trade more than 5% of its net assets
under foreign exchange contracts with one party.
Credit risk exists because the Fund's counterparty may be unable or
unwilling to fulfill its contractual obligations as a result of bankruptcy or
insolvency or when foreign exchange controls prohibit payment. In any foreign
exchange transaction, each party agrees to deliver a certain amount of currency
to the other on a particular date. In establishing its hedges the Fund relies on
each contract being completed. If the contract is not performed, then the Fund's
hedge is eliminated, and the Fund is exposed to any changes in exchange rates
since the contract was originated. To put itself in the same position it would
have been in had the contract been performed, the Fund must arrange a new
transaction. However, the new transaction may have to be arranged at an adverse
exchange rate. The trustee for a bankrupt company may elect to perform those
contracts which are advantageous to the company but disclaim those contracts
which are disadvantageous, resulting in losses to the Fund.
Another form of credit risk stems from the time zone differences between the
U.S. and foreign nations. If the Fund sells sterling it generally must pay
pounds to a counterparty earlier in the day than it will be credited with
dollars in New York. In the intervening hours, the buyer can go into bankruptcy
or can be declared insolvent. Thus, the dollars may never be credited to the
Fund.
COUNTRY RISK
At one time or another, virtually every country has interfered with
international transactions in its currency. Interference has taken the form of
regulation of the local exchange market, restrictions on foreign investment by
residents or limits on inflows of investment funds from abroad. Governments take
such measures for example to improve control over the domestic banking system or
to influence the pattern of receipts and payments between residents and
foreigners. In those cases, restrictions on the exchange market or on
international transactions are intended to affect the level or movement of the
exchange rate. Occasionally a serious foreign exchange shortage may lead to
payment interruptions or debt servicing delays, as well as interference in the
exchange market. It has become increasingly difficult to distinguish foreign
exchange or credit risk from country risk.
Changes in regulations or restrictions usually do have an important exchange
market impact. Most disruptive are changes in rules which interfere with the
normal payments mechanism. If government regulations change and a counterparty
is either forbidden to perform or is required to do something extra, then the
Fund might be left with an unintended open position or an unintended maturity
mismatch. Dealing with such unintended long or short positions could result in
unanticipated costs to the Fund.
Other changes in official regulations influence international investment
transactions. If one of the factors affecting the buying or selling of a
currency changes, the exchange rate is likely to respond. Changes in such
controls often are unpredictable and can create a significant exchange rate
response.
Many major countries have moved toward liberalization of exchange and
payments restrictions in recent years or accepted the principle that
restrictions should be relaxed. A few industrial countries have moved in the
other direction. Important liberalizations were carried out by Switzerland, the
United Kingdom and Japan. They dismantled mechanisms for restricting either
foreign exchange inflows (Switzerland), outflows (Britain) or elements of both
(Japan). By contrast, France and Mexico have recently tightened foreign exchange
controls.
Overall, many exchange markets are still heavily restricted. Several
countries limit access to the forward market to companies financing documented
export or import transactions in an effort to insulate the market from purely
speculative activities. Some of these countries permit local traders to enter
into forward contracts with residents but prohibit certain forward transactions
with nonresidents. By comparison, other countries have strict controls on
exchange transactions by residents, but permit free exchange transactions
between local traders and non-residents. A few countries have established tiered
markets, funneling commercial transactions through one market and financial
transactions through another. Outside the major industrial countries, relatively
free foreign exchange markets are rare and controls on foreign currency
transactions are extensive.
Another aspect of country risk has to do with the possibility that the Fund
may be dealing with a foreign trader whose home country is facing a payments
problem. Even though the foreign trader intends to perform on its foreign
exchange contracts, the contracts are tied to other external liabilities the
country has incurred. As a result performance may be delayed, and can result in
unanticipated cost to the Fund. This aspect of country risk is a major element
in the Fund's credit judgment as to with whom it will deal and in what amounts.
<PAGE>
EXHIBIT A
GLOSSARY OF TERMS
CLASS OF OPTIONS. Options covering the same underlying security.
CLEARING CORPORATION. The Options Clearing Corporation, Trans Canada
Options, Inc., The European Options Clearing Corporation B.V., or the London
Options Clearing House.
CLOSING PURCHASE TRANSACTION. A transaction in which an investor who is
obligated as a writer of an option or seller of a futures contract terminates
his obligation by purchasing on an Exchange an option of the same series as the
option previously written or futures contract identical to the futures contract
previously sold, as the case may be. (Such a purchase does not result in the
ownership of an option or futures contract.)
CLOSING SALE TRANSACTION. A transaction in which an investor who is the
holder or buyer of an outstanding option or futures contract liquidates his
position as a holder or seller by selling an option of the same series as the
option previously purchased or futures contract identical to the futures
contract previously purchased. (Such sale does not result in the investor
assuming the obligations of a writer or seller.)
COVERED CALL OPTION WRITER. A writer of a call option who, so long as he
remains obligated as a writer, owns the shares of the underlying security or
holds on a share for share basis a call on the same security where the exercise
price of the call held is equal to or less than the exercise price of the call
written, or, if greater than the exercise price of the call written, the
difference is maintained by the writer in cash, U.S. Treasury bills or other
high grade, short term obligations in a segregated account with the writer's
broker or custodian.
COVERED PUT OPTION WRITER. A writer of a put option who, so long as he
remains obligated as a writer, has deposited Treasury bills with a value equal
to or greater than the exercise price with a securities depository and has
pledged them to the Options Clearing Corporation for the account of the
broker-dealer carrying the writer's position or holds on a share for share basis
a put on the same security as the put written where the exercise price of the
put held is equal to or greater than the exercise price of the put written, or,
if less than the exercise price of the put written, the difference is maintained
by the writer in cash, U.S. Treasury bills or other high grade, short term
obligations in a segregated account with the writer's broker or custodian.
SECURITIES EXCHANGE. A securities exchange on which call and put options are
traded. The U.S. Exchanges are as follows The Chicago Board Options Exchange;
American Stock Exchange; New York Stock Exchange; Philadelphia Stock Exchange;
and Pacific Stock Exchange. The foreign securities exchanges in Canada are the
Toronto Stock Exchange and the Montreal Stock Exchange; in the Netherlands, the
European Options Exchange; and in the United Kingdom, the Stock Exchange
(London).
Those issuers whose common stocks have been approved by the Exchanges as
underlying securities for options transactions are published in various
financial publications.
COMMODITIES EXCHANGE. A commodities exchange on which futures contracts are
traded which is regulated by exchange rules that have been approved by the
Commodity Futures Trading Commission. The U.S. exchanges are as follows: The
Chicago Board of Trade of the City of Chicago, Chicago Mercantile Exchange,
International Monetary Market, (a division of the Chicago Mercantile Exchange),
the Kansas City Board of Trade and the New York Futures Exchange.
EXERCISE PRICE. The price per unit at which the holder of a call option may
purchase the underlyng security upon exercise or the holder of a put option may
sell the underlying security upon exercise.
EXPIRATION DATE. The latest date when an option may be exer- cised or a
futures contract must be completed according to its terms.
HEDGING. An action taken by an investor to neutralize an investment risk by
taking an investment position which will move in the opposite direction as the
risk being hedged so that a loss (or gain) on one will tend to be offset by a
gain (or loss) on the other.
OPTION. Unless the context otherwise requires, the term "option" means
either a call or put option issued by a Clearing Corporation, as defined above.
A call option gives a holder the right to buy from such Clearing Corporation the
number of shares of the underlying security covered by the option at the stated
exercise price by the filing of an exercise notice prior to the expiration time
of the option. A put option gives a holder the right to sell to a Clearing
Corporation the number of shares of the underlying security covered by the put
at the stated exercise price by the filing of an exercise notice prior to the
expiration time of the option. The Fund will sell ("write") and purchase puts
only on U.S. Exchanges.
OPTION PERIOD. The time during which an option may be exercised, generally
from the date the option is written through its expiration date.
PREMIUM. The price of an option agreed upon between the buyer and writer or
their agents in a transaction on the floor of an Exchange.
SERIES OF OPTIONS. Options covering the same underlying security and having
the same exercise price and expiration date.
STOCK INDEX. A stock index assigns relative values to the common stocks
included in the index, and the index fluctuates with chanqes in the market
values of the common stocks so included.
INDEX BASED FUTURES CONTRACT. An index based futures contract is a bilateral
agreement pursuant to which a party agrees to buy or deliver at settlement an
amount of cash equal to $500 times the difference between the closing value of
an index on the expiration date and the price at which the futures contract is
originally struck. Index based futures are traded on Commodities Exchanges.
Currently index based stock index futures contracts can be purchased or sold
with respect to the Standard & Poor's Corporation (S&P) 500 Stock Index and S&P
100 Stock Index on the Chicago Mercantile Exchange, the New York Stock Exchange
Composite Index on the New York Futures Exchange and the Value Line Stock Index
and Major Market Index on the Kansas City Board of Trade.
UNDERLYING SECURITY. The security subject to being purchased upon the
exercise of a call option or subject to being sold upon the exercise of a put
option.
<PAGE>
SCHEDULE OF INVESTMENTS-December 31, 1993
<TABLE>
<CAPTION>
Coupon Maturity Principal Market
Rate Date Amount Value
<S> <C> <C> <C> <C>
MUNICIPAL BONDS (95.8%)
ALASKA
North Slope Borough, Alaska, General Obligation 10.500% 06/30/1996 $ 1,045,000 $ 1,099,863
North Slope Borough, Alaska, General Obligation 8.350 06/30/1998 2,000,000 2,315,000
North Slope Borough, Alaska, General Obligation (effective yield
5.900%)(b) 0.000 06/30/2003 3,000,000 3,213,750
ARIZONA
Chanaler, Arizona, Water and Sewer 6.750 07/01/2006 850,000 954,125
Maricopa County, Arizona, Industrial Development Authority,
Hospital Facilities, Samaritan Health Services 9.250 12/01/2015 10,715,000 11,974,013
* Maricopa County, Arizona, School District, Kyrene Elementary
(effective yield 5.700%) (b) 0.000 01/01/2006 7,000,000 3,762,500
Maricopa County, Arizona, University School District 8.125 01/01/2010 6,000,000 7,440,000
Northern Arizona University 6.300 06/01/2005 1,000,000 1,101,250
* Phoenix, Arizona, Street and Highway, Series 1992A (effective
yield 5.950%) (b) 0.000 07/01/2013 2,500,000 856,250
Pima County, Arizona, Industrial Development Authority, Health
Care Corp., Carandolet St. Joseph and St. Mary Hospitals 8.000 07/01/2013 3,385,000 3,935,063
* Salt River Project, Arizona, Agricultural Improvement, Series C 5.000 01/01/2016 10,000,000 9,637,500
Salt River, Arizona, AIPD Electric 6.000 01/01/2009 2,500,000 2,721,875
ARKANSAS
Arkansas State Development Finance Authority, SFMR Refunding 8.000 08/15/2011 2,310,000 2,500,575
CALIFORNIA
California Board of Public Works 5.375 12/01/2019 7,750,000 7,759,688
California Board of Public Works, Community College Project 5.000 12/01/2019 10,500,000 10,145,625
* California State Public Works Board, Series A 5.500 06/01/2014 3,700,000 3,737,000
* Eden Township, California, Hospital District 7.400 11/01/2019 5,615,000 6,036,125
Los Angeles County Transportation Commission 6.250 07/01/2013 5,500,000 5,953,750
* Los Angeles County, California, Metropolitan Transportation
Authority, Sales Tax 5.000 07/01/2021 4,490,000 4,265,500
* Los Angeles, California, Electric Plant, Second Issue 5.125 10/15/2015 2,200,000 2,142,250
Northern California Power Agency 10.298 08/15/2017 9,000,000 10,642,500
Oakland, California, Pensions 7.600 08/01/2021 6,015,000 6,909,731
Oakland, California, Redevelopment Agency, Tax Allocation Central
District 5.000 09/01/2013 2,980,000 2,894,325
Orange County, California, Local Transportation Authority 9.226 02/14/2011 3,500,000 4,274,375
* Sacramento County, California, Sanitation District 5.000 12/01/2016 3,215,000 3,094,438
San Joaquin Hills, California, Transportation Corridor Agency,
Toll Road 7.000 01/01/2030 10,500,000 10,710,000
* San Jose, California, Redevelopment Tax Allocation 5.000 08/01/2020 7,250,000 6,941,875
<PAGE>
Coupon Maturity Principal Market
Rate Date Amount Value
CALIFORNIA (continued)
* Southern California Public Power Authority, Power Project 5.000% 01/01/2020 $ 2,500,000 $ 2,390,625
* University of California 5.000 09/01/2023 27,000,000 25,650,000
COLORADO
City and County of Denver, Colorado, Airport System 7.750 11/15/2021 4,250,000 4,770,625
City and County of Denver, Colorado, Airport System 7.250 11/15/2023 3,715,000 4,067,925
City and County of Denver, Colorado, Airport System 8.750 11/15/2023 16,380,000 19,512,675
City and County of Denver, Colorado, Airport System 7.000 11/15/2025 8,040,000 8,522,400
Colorado Health Facilities Authority, Rocky Mountain Adventist
Health Care 6.625 02/01/2022 3,000,000 3,138,750
Denver, Colorado, City and County Airport System 8.000 11/15/2025 525,000 592,594
Larimer County, Colorado, School District 7.000 12/15/2016 2,250,000 2,823,750
CONNECTICUT
Connecticut Special Tax Obligation, Series B 6.500 10/01/2012 1,600,000 1,852,000
DELAWARE
Delaware Health Facilities Authority, Medical Center of Delaware 6.250 10/01/2006 6,000,000 6,750,000
Delaware State Housing Authority, Home Mortgage 13.400 01/01/2004 175,000 178,500
DISTRICT OF COLUMBIA
District of Columbia 6.000 06/01/2011 7,000,000 7,262,500
FLORIDA
Brevard County, Florida, Health Facilities Authority Refunding,
Wuesthoff Memorial Hospital 7.200 04/01/2013 1,100,000 1,207,250
Broward County, Florida, Resource Recovery, South Project 7.950 12/01/2008 3,865,000 4,377,113
* Broward County, Florida, Water and Sewer Utility 5.000 10/01/2018 9,050,000 8,767,188
Dade County, Florida, Public Facilities, Jackson Memorial
Hospital 5.250 06/01/2023 5,875,000 5,728,125
* Dade County, Florida, Water Sewer Systems, Allegheny Health
Systems, St. Mary's 5.000 10/01/2013 1,500,000 1,456,875
* Florida State Board of Education, Capital Outlay 5.125 06/01/2022 10,040,000 9,776,450
Florida State Department Transportation Turnpike 5.000 07/01/2013 1,700,000 1,657,500
Gainesville, Florida, Utilities Systems 7.500 10/01/2009 3,695,000 4,586,419
Jacksonville, Florida, Health Facility Authority 7.000 06/01/2021 1,800,000 2,052,000
Jacksonville, Florida, Transportation Authority 9.200 01/01/2015 2,000,000 2,992,500
* Key West, Florida, Utility System (effective yield 5.500%) (b) 0.000 10/01/2017 4,000,000 1,075,000
Lee County, Florida, School Board, COP 7.750 08/01/2005 4,990,000 6,012,950
Orlando-Orange County, Florida, Expressway Authority 8.250 07/01/2015 2,960,000 4,058,900
* Orlando-Orange County, Florida, Expressway Authority 5.125 07/01/2020 5,000,000 4,856,250
* South Broward Hospital District, Florida, Series 1993 5.375 05/01/2013 9,275,000 9,240,219
St. Petersburg, Florida, Health Facilities Authority 7.000 12/01/2015 3,250,000 3,757,813
Tampa, Florida, Subordinated Guaranteed Entitlement 8.500 10/01/2018 1,825,000 2,185,438
<PAGE>
Coupon Maturity Principal Market
Rate Date Amount Value
GEORGIA
Burke County, Georgia, Development Authority, Pollution Control,
Georgia Power Co. 12.250% 08/01/2014 $ 4,000,000 $ 4,275,000
Metropolitan Atlanta Rapid Transit Authority, Georgia, Sales Tax 6.250 07/01/2011 4,255,000 4,813,469
Monroe County, Georgia, Development Authority, Pollution Control,
Georgia Power Co. 11.625 03/01/2014 2,900,000 3,023,250
Monroe County, Georgia, Development Authority, Pollution Control,
Georgia Power Co. 10.500 09/01/2015 7,100,000 7,996,375
* Municipal Electric Authority, Georgia 7.000 01/01/2008 5,000,000 5,887,500
Municipal Electric Authority, Georgia 6.400 01/01/2013 3,500,000 4,003,125
Municipal Electric Authority, Georgia, Special Obligation 6.500 01/01/2017 2,000,000 2,300,000
HAWAII
City and County of Honolulu, Hawaii, General Obligation 5.250 10/01/2012 3,450,000 3,501,750
Hawaii State Department of Budget and Finance, Special Purpose,
Hawaii Electric Co. 7.375 12/01/2020 8,000,000 9,200,000
State of Hawaii, Airport System 6.450 07/01/2013 10,000,000 11,087,500
IDAHO
Idaho Housing Finance Authority, Single Family Mortgage Bonds,
Series D-1 8.000 01/01/2020 1,930,000 2,031,325
ILLINOIS
Chicago, Illinois, People's Gas Supply 7.500 03/01/2015 4,000,000 4,610,000
Chicago, Illinois, People's Gas Light and Coke Co. 8.100 05/01/2020 6,740,000 7,944,775
* Chicago, Illinois, Water 6.500 11/01/2010 3,085,000 3,497,619
Cook County, Illinois, General Obligation 7.700 12/01/2005 5,970,000 7,350,563
Illinois Development Finance Authority, Pollution Control,
Commonwealth Edison Co. 10.625 03/01/2015 8,500,000 9,275,625
* Illinois Educational Facilities Authority, Northwestern
University 5.375 12/01/2021 4,000,000 3,965,000
* Illinois Health Facilities Authority 5.375 11/15/2013 8,375,000 8,343,594
Illinois Toll Highway Authority 6.300 01/01/2012 7,300,000 8,112,125
Kankakee, Illinois, Sewer 6.875 05/01/2011 2,965,000 3,424,575
Metropolitan Pier and Exposition Authority, McCormick Place
Expansion Project, Illinois 7.250 06/15/2005 9,500,000 11,245,625
INDIANA
Indiana State Housing Authority, Single Family Mortgage 11.250 01/01/2014 875,000 896,875
* Indiana State Office Building Commission Capital Complex 5.250 07/01/2015 6,540,000 6,384,675
* Indiana Transportation Finance Authority 6.800 12/01/2016 6,000,000 7,102,500
Indianapolis Local Public Improvement Bond Bank, Series 1992D 6.750 02/01/2020 2,000,000 2,172,500
<PAGE>
Coupon Maturity Principal Market
Rate Date Amount Value
KENTUCKY
Carroll County, Kentucky, Utilities 7.450% 09/15/2016 $ 5,000,000 $ 5,931,250
Kentucky Housing Corp. 7.900 01/01/2021 7,255,000 7,572,406
Trimble County, Kentucky, Pollution Control, Louisville Gas and
Electric Co. 7.625 11/01/2020 2,725,000 3,133,750
Trimble County, Kentucky, Pollution Control, Louisville Gas and
Electric Co. 7.625 11/01/2020 545,000 651,956
LOUISIANA
City of New Orleans, Louisiana, General Obligation (effective
yield 6.780%)(b) 0.000 09/01/2008 6,500,000 2,981,875
Louisiana Public Facilities Authority 8.200 12/01/2005 7,250,000 8,473,438
Louisiana State Offshore Term Authority 5.200 09/01/1997 4,000,000 4,175,000
Louisiana State Offshore Term Authority 6.100 09/01/2002 2,500,000 2,778,125
Louisiana State Offshore Term Authority 6.250 09/01/2004 3,700,000 4,171,750
New Orleans, Louisiana, General Obligation (effective yield
5.990%)(b) 0.000 09/01/2010 3,950,000 1,604,688
Orleans Parish, Louisiana, School Board 9.050 02/01/2010 5,175,000 7,257,938
MAINE
Regional Waste System, Maine 8.150 07/01/2011 2,500,000 2,925,000
MARYLAND
Maryland State Community Development Administration, Multi-Family
Housing 8.750 05/15/2012 3,345,000 3,470,438
MASSACHUSETTS
Massachusetts Bay Transportation Authority 5.400 03/01/2008 15,800,000 16,313,500
Massachusetts Bay Transportation Authority 6.200 03/01/2016 2,125,000 2,369,375
Massachusetts General Obligation (effective yield 6.800%)(b) 0.000 12/01/2003 6,000,000 3,727,500
Massachusetts General Obligation (effective yield 6.900%)(b) 0.000 06/01/2005 4,100,000 2,321,625
Massachusetts Health and Education Facilities Authority 5.750 07/01/2012 3,500,000 3,609,375
Massachusetts Industrial Finance Authority, Harvard Community
Health Plan, Inc. 8.125 10/01/2017 7,250,000 8,228,750
Massachusetts Municipal Wholesale Electric Co. 6.750 07/01/2008 4,000,000 4,415,000
* Massachusetts State Health and Education Facilities Authority 5.375 07/01/2011 1,500,000 1,507,500
Massachusetts State Health and Education Facilities Authority 6.200 10/01/2016 4,000,000 4,255,000
* Massachusetts State Health and Education Facilities Authority 5.375 07/01/2019 4,250,000 4,281,875
* Massachusetts State Health and Education Facilities Authority 5.000 07/01/2020 4,490,000 4,271,113
* Massachusetts State Health and Education Facilities Authority 5.250 11/15/2021 4,000,000 3,865,000
Massachusetts State Health and Education Facilities, Lahey Clinic
Medical Center 5.375 07/01/2023 3,800,000 3,766,750
Massachusetts State Health and Education, Capital Asset Program 7.300 10/01/2018 2,000,000 2,305,000
Massachusetts State Health and Education, Deaconess Hospital 6.875 04/01/2022 2,980,000 3,341,325
<PAGE>
Coupon Maturity Principal Market
Rate Date Amount Value
MASSACHUSETTS (continued)
Massachusetts State Housing Finance Agency, Single Family
Mortgage Purchase 9.500% 12/01/2016 $ 2,575,000 $2,690,875
Massachusetts State Port Authority 5.000 07/01/2018 4,680,000 4,481,100
* Massachusetts State Water Resources Authority 6.000 12/01/2011 6,000,000 6,390,000
Massachusetts State Water Resources Authority 6.500 07/15/2021 7,155,000 8,308,744
Massachusetts State Water Resources Authority 5.000 03/01/2022 4,000,000 3,700,000
MICHIGAN
* Brighton, Michigan, Area School District, Series I (effective
yield 5.810%)(b) 0.000 05/01/2010 9,065,000 3,807,300
Michigan State Hospital Finance Authority, Oakwood Hospital 7.100 07/01/2018 4,260,000 4,994,850
Michigan State Hospital Finance Authority, McLaren Obligated
Group 7.500 09/15/2021 2,955,000 3,601,406
Michigan State Hospital Finance Authority, Crittenton Hospital,
Series A 4.000 08/15/2022 2,725,000 2,616,000
Michigan State Hospital Finance Authority, Hospital Refunding
(Daughters Charity Health Systems - Providence Hospital) 10.000 11/01/2015 7,980,000 9,007,425
Monroe County, Michigan, Economic Development Corp., Detroit
Edison Co. 6.950 09/01/2022 6,000,000 7,440,000
River Rouge, Michigan, School District 5.625 05/01/2022 5,300,000 5,452,375
MINNESOTA
Dakota County, Minnesota, Housing and Redevelopment Authority,
Single Family Mortgage 9.375 05/01/2018 50,000 53,813
Minnesota Housing Finance Agency, Housing Development,
Residential Mortgage 6.500 01/01/2026 3,500,000 3,692,500
Minnesota Housing Finance Agency, Housing Development,
Residential Mortgage 10.000 07/01/2016 2,170,000 2,300,200
MISSISSIPPI
Mississippi Hospital Equipment and Facilities 6.400 01/01/2007 1,000,000 1,095,000
Mississippi Hospital Equipment and Facilities Authority, North
Mississippi Health Service 5.250 05/15/2013 5,000,000 4,956,250
MISSOURI
Health and Education Facilities Authority, Missouri Health
Facility 6.250 06/01/2016 5,750,000 6,238,750
* Missouri State Health and Education Facility 5.350 06/01/2010 3,610,000 3,668,663
NEBRASKA
* Nebraska Public Power District 5.000 01/01/2017 2,000,000 1,917,500
* Omaha Public Power District, Nebraska Electric 5.500 02/01/2014 6,000,000 6,180,000
NEVADA
Clark County, Nevada, General Obligation 7.500 06/01/2009 4,000,000 4,975,000
Clark County, Nevada, School District 6.750 03/01/2007 3,000,000 3,363,750
<PAGE>
Coupon Maturity Principal Market
Rate Date Amount Value
NEVADA (continued)
Nevada State Refunding 6.600% 10/01/2016 $ 4,000,000 $4,420,000
NEW HAMPSHIRE
New Hampshire Higher Educational and Health Facilities Authority,
Hospital Bonds (Mary Hitchcock Memorial Hospital Issue), Series
1985H 5.375 06/01/2023 6,000,000 6,037,500
NEW JERSEY
New Jersey Health Care Facilities Financing Authority, St.
Elizabeth's Hospital 7.750 07/01/1998 1,850,000 1,974,875
New Jersey Health Care Facilities Financing Authority, General
Hospital Center at Passaic, Inc. 10.125 07/01/2002 1,800,000 1,977,750
New Jersey Health Care Facilities Financing Authority, Kimball
Medical Center 8.000 07/01/2013 3,000,000 3,360,000
New Jersey Health Care Facilities Financing Authority, Our Lady
of Lourdes Medical Center 9.750 02/01/2015 4,350,000 4,703,438
New Jersey Health Care Facilities Financing Authority, General
Hospital Center at Passaic, Inc. 9.625 08/01/2025 7,500,000 8,278,125
New Jersey Health Care Facilities Financing Authority, General
Hospital Center at Passaic, Inc. 10.375 07/01/2014 3,850,000 4,230,188
NEW MEXICO
City of Albuquerque, New Mexico, Hospital System 6.375 08/01/2007 1,500,000 1,657,500
Farmington, New Mexico, Pollution Control 5.875 06/01/2023 8,700,000 9,102,375
NEW YORK
* Battery Park, City Authority, New York Refunding Bonds 5.000 11/01/2013 4,500,000 4,325,625
New York City, New York, General Obligation 6.000 08/01/2006 285,000 298,894
New York City, New York, General Obligation 7.500 02/01/2007 1,800,000 2,067,750
New York City, New York, General Obligation 7.000 02/01/2008 4,000,000 4,410,000
New York City, New York, General Obligation 7.750 08/15/2008 6,000,000 7,072,500
New York City, New York, General Obligation 7.700 02/01/2009 3,000,000 3,528,750
* New York City, New York, General Obligation 5.500 10/01/2011 6,000,000 5,805,000
* New York City, New York, General Obligation 6.334 10/01/2013 3,000,000 3,015,000
New York City, New York, General Obligation 7.750 08/15/2014 5,460,000 6,395,025
New York City, New York, General Obligation 7.750 08/15/2015 3,250,000 3,806,563
New York City, New York, Municipal Water Finance Authority, Water
and Sewer System 7.000 06/15/2015 6,000,000 6,772,500
New York State Dormitory Authority, State University Educational
Facilities 7.000 07/01/2009 5,000,000 6,062,500
New York State Energy Research and Development Authority 7.150 06/01/2020 2,000,000 2,185,000
New York State Energy Research and Development Authority 7.150 02/01/2022 8,000,000 8,740,000
New York State Energy Research and Development Authority,
Consolidated Edison Project 7.750 01/01/2024 2,900,000 3,280,625
New York State Environment Facilities Corp. 6.875 06/15/2010 5,000,000 5,756,250
<PAGE>
Coupon Maturity Principal Market
Rate Date Amount Value
NEW YORK (continued)
* New York State Local Government Assistance Corp. 6.000% 04/01/2014 $10,000,000 $10,862,500
New York State Local Government Assistance Corp. 11.816 04/01/2020 8,000,000 11,600,000
* New York State Local Government Assistance Corp. 5.000 04/01/2021 5,000,000 4,750,000
New York State Local Government Assistance Corp. 6.750 04/01/2021 900,000 1,057,500
* New York State Local Government Assistance Corp., Series B 5.375 04/01/2016 5,800,000 5,778,250
New York State Mortgage Agency 6.900 04/01/2015 4,500,000 4,944,375
New York State Power Authority and General Purpose 6.500 01/01/2019 5,000,000 5,506,250
Onondaga County, Resource Recovery Agency, New York 6.875 05/01/2006 10,000,000 10,737,500
Westchester County, New York, Industrial Development Agency (HRCC
Inc. Project), SCM Corp. 11.750 05/24/2004 3,000,000 2,985,000
NORTH CAROLINA
North Carolina Eastern Municipal Power Agency, Power Systems 7.250 01/01/2007 11,000,000 13,076,250
North Carolina Eastern Municipal Power Agency, Power Systems 6.250 01/01/2012 5,100,000 5,310,375
* North Carolina Eastern Municipal Power Agency, Power Systems 7.000 01/01/2013 6,000,000 7,042,500
North Carolina Eastern Municipal Power Agency, Power Systems 6.500 01/01/2017 5,800,000 6,162,500
North Carolina Eastern Municipal Power Agency, Power Systems 6.500 01/01/2018 1,210,000 1,350,663
North Carolina Eastern Municipal Power Agency, Power Systems 6.250 01/01/2023 5,000,000 5,368,750
North Carolina Municipal Power Agency 7.250 01/01/2007 30,500,000 36,409,375
North Carolina Municipal Power Agency 5.000 01/01/2015 2,950,000 2,761,938
Raleigh-Durham, North Carolina, Airport Authority, Special
Facility, American Airlines, Inc. Project 9.625 11/01/2015 13,500,000 14,596,875
NORTH DAKOTA
North Dakota State Housing Finance Agency, Single Family Mortgage 8.375 07/01/2021 1,155,000 1,232,963
OHIO
Columbus, Ohio, General Obligation 12.375 02/15/2006 1,285,000 2,134,706
Hamilton, Ohio, Electric Systems 6.300 10/15/2025 1,365,000 1,499,794
Lucas County, Ohio, Toledo Hospital 9.625 10/01/2014 1,000,000 1,060,000
Ohio Housing Finance Agency, Single Family Mortgage 9.000 01/15/2009 975,000 1,015,219
Ohio State Water Development Authority 9.250 12/01/2012 835,000 923,938
Ohio State Water Development Authority 9.375 12/01/2018 3,840,000 4,256,800
OKLAHOMA
Grand River, Oklahoma, Dam Authority 5.500 06/01/2009 12,000,000 12,420,000
PENNSYLVANIA
Beaver County, Pennsylvania, Ohio Edison 7.000 06/01/2021 4,190,000 4,771,363
City of Pottsville, Pennsylvania, Hospital Authority (Daughters
of Charity Health Systems, Inc.), Good Samaritan Hospital 8.250 08/01/2012 2,735,000 3,117,900
* Delaware County, Pennsylvania Authority Health Care, Mercy Health
Company of Southeast 5.375 11/15/2023 5,000,000 4,850,000
Delaware County, Pennsylvania, Hospital, Crozier Chester Medical
Center 7.500 12/15/2020 2,500,000 2,921,875
<PAGE>
Coupon Maturity Principal Market
Rate Date Amount Value
PENNSYLVANIA (continued)
Delaware County, Pennsylvania, Industrial Development Authority,
Resource Recovery Project 8.100% 12/01/2013 $4,000,000 $4,405,000
Guthrie Health Systems Care Facility of Sayre, Pennsylvania 7.100 03/01/2017 1,250,000 1,434,375
Hampden Township, Pennsylvania, Sewer Authority (effective yield
6.950%)(b) 0.000 04/01/2005 1,410,000 805,463
Lehigh County, Pennsylvania, Power & Light 6.400 11/01/2021 3,000,000 3,281,250
Northumberland County, Pennsylvania, Authority Prisons Lease 7.750 10/15/2004 2,110,000 2,571,563
Pennsylvania Convention Center Authority (effective yield
6.900%)(b) 0.000 09/01/2006 3,350,000 1,762,938
Pennsylvania Housing Finance Agency, Single Family Mortgage 7.750 10/01/2009 4,000,000 4,285,000
Pennsylvania Housing Finance Agency, Single Family Mortgage 6.850 04/01/2016 500,000 541,250
Pennsylvania Housing Finance Agency, Single Family Mortgage 8.200 07/01/2024 6,000,000 6,720,000
Pennsylvania Housing Finance Agency, Single Family Mortgage 10.166 04/01/2025 2,800,000 2,943,500
* Pennsylvania Intergovernmental Cooperative Authority 5.600 06/15/2015 2,000,000 2,037,500
* Pennsylvania Intergovernmental Cooperative Authority 5.750 06/15/2015 6,000,000 6,105,000
* Pennsylvania Intergovernmental Cooperative Authority 5.000 06/15/2023 7,750,000 7,381,875
* Pennsylvania Intergovernmental Cooperative Authority 5.625 06/15/2023 5,000,000 5,068,750
Philadelphia, Pennsylvania, Gas Works 6.375 07/01/2026 2,000,000 2,120,000
Philadelphia, Pennsylvania, Hospital and Higher Education
Facilities Authority, Series A, Graduate Health System 6.250 07/01/2019 2,000,000 2,022,500
Philadelphia, Pennsylvania, Hospital and Higher Education
Facilities 7.250 07/01/2018 2,500,000 2,718,750
Philadelphia, Pennsylvania, Hospital and Higher Education
Facilities 7.000 10/01/2021 3,055,000 3,326,131
Philadelphia, Pennsylvania, Hospital and Higher Education
Facilities 6.500 11/15/2022 5,000,000 5,300,000
Philadelphia, Pennsylvania, Hospital and Higher Education
Facilities Authority, Hospital, Temple University 6.625 11/15/2023 1,725,000 1,815,563
* Philadelphia, Pennsylvania, Municipal Authority, Series A 5.625 11/15/2018 5,990,000 6,102,313
Philadelphia, Pennsylvania, Municipal Development Authority
Criminal Justice Center, Series A 7.100 11/15/2006 4,095,000 4,755,319
Philadelphia, Pennsylvania, Municipal Development Authority,
Criminal Justice Center, Series B 7.100 11/15/2006 4,000,000 4,755,000
Philadelphia, Pennsylvania, Municipal Development Authority,
Criminal Justice Center, Series A 7.800 04/01/2018 3,000,000 3,510,000
* Philadelphia, Pennsylvania, Water and Wastewater 10.000 06/15/2005 7,000,000 9,992,500
* Philadelphia, Pennsylvania, Water and Wastewater 5.750 06/15/2013 1,700,000 1,683,000
Pittsburgh, Pennsylvania, Urban Redevelopment Authority,
Multi-Family Housing Mortgage 9.250 12/01/2027 3,215,000 3,423,975
Pittsburgh, Pennsylvania, Water and Sewer Authority (effective
yield 6.700%)(b) 0.000 09/01/2008 5,000,000 2,325,000
<PAGE>
Coupon Maturity Principal Market
Rate Date Amount Value
PUERTO RICO
Puerto Rico Commonwealth, Aqueduct and Sewer Authority 7.875% 07/01/2017 $ 5,805,000 $ 6,712,031
Puerto Rico Commonwealth, General Obligation 7.000 07/01/2010 12,000,000 14,250,000
Puerto Rico Commonwealth, General Obligation 7.700 07/01/2020 1,960,000 2,381,400
* Puerto Rico Commonwealth, Highway and Transportation Authority 5.000 07/01/2022 2,750,000 2,574,688
Puerto Rico Commonwealth, Telephone Authority 5.400 01/01/2008 3,500,000 3,591,875
RHODE ISLAND
Rhode Island Economic Protection Corp., Special Obligation Bonds 7.500 08/01/2014 2,500,000 3,040,625
Rhode Island State Health and Educational Building Corp.,
Hospital Financing, Roger Williams General Hospital 9.500 07/01/2016 4,210,000 4,562,588
* Rhode Island State Industrial Facilities Corp. 6.000 11/01/2014 5,000,000 5,300,000
SOUTH CAROLINA
South Carolina State Housing Authority, Home Ownership Mortgage
Purchase 9.375 07/01/2016 2,860,000 3,020,875
* South Carolina State Public Service 5.125 01/01/2021 19,000,000 18,097,500
* South Carolina State Public Service, Santee Cooper, Series C 5.000 01/01/2014 3,500,000 3,386,250
Sumter County, South Carolina, Hospital Facilities, The Tuomey
Hospital 10.000 10/01/2004 250,000 278,125
TENNESSEE
Bristol, Tennessee, Health and Education Authority, Bristol
Memorial Hospital 7.000 09/01/2021 5,200,000 6,097,000
* Bristol, Tennessee, Health and Education Facilities Board 4.250 09/01/1998 1,400,000 1,405,250
* Bristol, Tennessee, Health and Education Facilities Board 6.750 09/01/2007 3,640,000 4,231,500
Chattanooga-Hamilton County, Tennessee, Hospital Authority 8.350 05/25/2021 3,200,000 4,248,000
Knox County, Tennessee, Fort Sanders 7.000 01/01/2015 11,750,000 13,585,938
* Knox County, Tennessee, Health and Education Facilities, Fort
Sanders Hospital 7.250 01/01/2010 3,000,000 3,648,750
Tennessee Housing Development Authority, Homeownership Program 7.825 07/01/2015 8,220,000 8,877,600
TEXAS
Austin, Texas, Combined Utility System 10.000 05/15/2005 5,000,000 6,587,500
Austin, Texas, Combined Utility System (effective yield
6.170%)(b) 0.000 11/15/2009 4,740,000 2,032,275
Bexar County, Texas, Health Facilities Development Corp.,
Incarnate Word Health Services 9.500 11/01/2015 8,640,000 9,741,600
Harris County, Texas, Cultural Education Facilities Finance Corp.
(Space Center Houston Project) 9.250 08/15/2015 3,000,000 3,536,250
Harris County, Texas, Flood Control District (effective yield
7.200%)(b) 0.000 10/01/2006 4,500,000 2,092,500
* Houston, Texas 7.000 03/01/2008 5,000,000 5,993,750
<PAGE>
Coupon Maturity Principal Market
Rate Date Amount Value
TEXAS (continued)
Houston, Texas, Airport 8.200% 07/01/2017 $ 1,840,000 $ 2,141,300
* Lubbock, Texas, Housing Finance Corp., Single Family Mortgage
(effective yield 5.800%)(b) 0.000 10/01/2015 6,415,000 1,772,144
Port of Corpus Christi, Texas, Industrial Development Corp.
(Valero Refining and Marketing Co. Project) 10.250 06/01/2017 11,050,000 13,204,750
Rio Grande Valley, Texas, Health Facilities Corp., Hospital,
Baptist Medical Center Project 8.000 08/01/2017 1,085,000 1,262,669
Rio Grande Valley, Texas, Health Facilities Corp., Hospital,
Baptist Medical Center Project 8.000 08/01/2017 5,915,000 7,016,669
San Antonio, Texas, Electric and Gas (effective yield 7.050%)(b) 0.000 02/01/2007 10,000,000 5,050,000
San Antonio, Texas, Electric and Gas (effective yield 7.090%)(b) 0.000 02/01/2010 8,000,000 3,350,000
State of Texas Veterans Housing Assistance, Series 1992, General
Obligation 6.050 12/01/2012 2,695,000 2,765,744
Tarrant County, Texas, Health Facilities Development Corp., Fort
Worth Osteopathic 6.000 05/15/2021 5,060,000 5,540,700
Texas Housing Agency, Residential Development Authority 8.400 01/01/2021 3,730,000 3,995,763
Texas Municipal Power Agency 6.100 09/01/2009 8,870,000 9,779,175
Texas Municipal Power Agency (effective yield 6.800%)(b) 0.000 09/01/2012 4,000,000 1,445,000
Texas National Research Laboratory, Commission Financing Corp.
Lease 7.100 12/01/2021 2,390,000 2,461,700
Texas State Public Finance Authority 6.250 08/01/2009 4,310,000 4,794,875
Titus County, Texas, Fresh Water District Supply, Southwest
Electric Power 8.200 08/01/2011 5,500,000 6,703,125
* Tomball, Texas, Hospital Authority 6.100 07/01/2008 6,860,000 6,860,000
* Tomball, Texas, Hospital Authority 6.125 07/01/2023 3,000,000 2,936,250
Travis County, Texas Health Facilities, Daughters Of Charity 6.000 11/15/2022 1,800,000 1,845,000
UTAH
Intermountain Power Agency, Utah, Power Supply (effective yield
6.250%)(b) 0.000 07/01/2012 20,350,000 17,831,688
Intermountain Power Agency, Utah, Power Supply (effective yield
7.090%)(b) 0.000 07/01/2004 8,000,000 4,770,000
Intermountain Power Agency, Utah, Special Obligation 7.875 07/01/2014 4,210,000 4,652,050
Intermountain Power Agency, Utah, Power Supply (effective yield
6.800%)(b) 0.000 07/01/2020 3,000,000 420,000
Intermountain Power Agency, Utah, Power Supply 5.500 07/01/2020 13,185,000 13,119,075
Intermountain Power Agency, Utah, Power Supply 12.265 07/01/2020 12,000,000 15,375,000
Intermountain Power Agency, Utah, Power Supply 5.000 07/01/2023 7,815,000 7,394,944
Salt Lake City, Utah, Intermountain Health Care Inc. 7.600 02/15/2020 2,975,000 3,499,344
Utah State Housing Finance Agency, Single Family Mortgage 10.750 07/01/2008 275,000 287,031
Utah State Housing Finance Agency, Single Family Mortgage 7.950 07/01/2010 2,290,000 2,498,963
VERMONT
Vermont Educational and Health Buildings Agency, Series 1993 10.380 09/01/2019 7,600,000 8,293,500
<PAGE>
Coupon Maturity Principal Market
Rate Date Amount Value
VIRGINIA
* Augusta County, Virginia, Industrial Development Authority 5.500% 09/01/2015 $ 2,500,000 $ 2,528,125
* Upper Occoquan, Sewage Authority, Virginia 5.000 07/01/2015 2,500,000 2,409,375
Virginia Department of Transportation Board 9.981 04/01/2018 8,000,000 9,570,000
Virginia State Housing Development Authority (effective yield
9.970%)(b) 0.000 09/01/2014 590,000 74,488
Virginia State Housing Development Authority 8.375 01/01/2028 6,240,000 6,598,800
* Virginia State Transportation Board, Transportation Contract 5.250 05/15/2019 3,750,000 3,735,938
WASHINGTON
Washington Public Power Supply System Project #3, Series 1991A 6.500 07/01/2018 11,750,000 12,645,938
Washington State Health Care Facilities Authority 6.300 11/15/2022 2,500,000 2,706,250
Washington State Health Care Facilities Authority, Multi-Care
Medical Center of Tacoma 7.875 08/15/2011 1,300,000 1,501,500
Washington State Housing Finance Authority 11.006 12/01/2017 3,100,000 3,522,375
Washington State Public Power Supply System, #2 7.625 07/01/2010 5,000,000 5,881,250
Washington State Public Power Supply System, #3 (effective yield
7.200%)(b) 0.000 07/01/2006 3,000,000 1,563,750
Washington State Public Power Supply System, #3 (effective yield
7.250%)(b) 0.000 07/01/2006 5,755,000 3,014,181
Washington State Public Power Supply System, #3 (effective yield
7.480%)(b) 0.000 07/01/2010 5,000,000 2,006,250
Washington State Public Power Supply System, #1 7.125 07/01/2016 17,320,000 20,784,000
Washington State Public Power Supply System, #3 (effective yield
7.230%)(b) 0.000 07/01/2010 2,500,000 996,875
* Washington State Public Power Supply System, Nuclear Project
Number 3 5.600 07/01/2015 10,000,000 10,100,000
WISCONSIN
Wisconsin Health and Education Facilities Authority, Bellin
Memorial Hospital, Inc. 7.625 04/01/2019 5,000,000 5,793,750
Wisconsin Housing and Economic Development Authority, Home
Ownership 8.000 03/01/2021 2,785,000 3,046,094
Wisconsin State Transportation, Series A 5.500 07/01/2022 4,000,000 4,025,000
WYOMING
Wyoming Community Development Authority, Single Family Mortgage 8.125 06/01/2021 2,245,000 2,399,322
TOTAL MUNICIPAL BONDS (Cost-$1,369,532,104) $1,483,608,425
<PAGE>
Coupon Maturity Principal Market
Rate Date Amount Value
TEMPORARY TAX-EXEMPT INVESTMENTS (1.6%)
City of Atlantic Beach, Florida, Variable Rate Demand Bonds
(Fleet Landing Project) (a) 2.900% 02/01/2019 $1,455,000 $ 1,455,000
City of New York, General Obligation Bonds, Fiscal 1993
Series B (a) 3.650 10/01/2021 2,000,000 2,000,000
Commonwealth of Puerto Rico, Tax and Revenue Anticipation Notes,
Series 1994A (a) 3.000 07/29/1994 4,000,000 4,006,672
New Hampshire Higher Educational and Health Facilities Authority
Revenue (a) 3.000 01/01/2021 2,000,000 2,000,000
Newport Beach, California, Variable Rate Demand Revenue Bonds
(Hoag Memorial Hospital Presbyterian), Series 1992 (a) 4.450 10/01/2022 2,520,000 2,520,000
Perry County, Mississippi Pollution Control Refunding Revenue
Bonds (Leaf River Forest Product Inc.), Series 1992 (a) 4.750 03/01/2002 5,000,000 5,000,000
Philadelphia, Pennsylvania, Redevelopment Authority, School
Revenue Bonds (Pennsylvania School for the Deaf) (a) 3.100 12/01/2014 1,795,000 1,795,000
Texas State Department Housing and Community Affairs,
Multi-Family Housing Revenue Refunding Bonds (High Point III
Development), Series 1993A (a) 2.900 02/01/2023 1,570,000 1,570,000
Texas State Tax and Revenue Anticipation Notes, Series 1993 (a) 3.250 08/31/1994 3,000,000 3,009,152
Washington State Housing Finance Commission, Nonprofit Housing
Revenue Bonds (Emerald Heights Project), Series 1990 (a) 4.400 01/01/2021 1,900,000 1,900,000
TOTAL TEMPORARY TAX-EXEMPT INVESTMENTS (Cost- $25,255,824) 25,255,824
certificate of deposit (0.0%)
State Street Bank & Trust Co. (Cost $150,900) 2.500 01/31/1994 150,900 150,900
TOTAL INVESTMENTS (Cost-$1,394,938,828)(c) 1,509,015,149
OTHER ASSETS AND LIABILITIES-NET (2.6%) 39,488,190
NET ASSETS (100.0%) $1,548,503,339
</TABLE>
<PAGE>
Notes to Schedule of Investments:
(a) Variable or floating rate instruments with periodic demand features. The
Fund is entitled to full payment of principal and accrued interest upon
surrendering the security to the issuing agent according to the terms of the
demand features.
(b) Effective yield (calculated at the date of purchase) is the yield at which
the bond accretes on an annual basis until maturity date.
(c) The cost of investments for federal income tax purposes amounted to
$1,394,301,193. Gross unrealized appreciation and depreciation of investments,
based on identified tax cost, at December 31, 1993, are as follows:
Gross unrealized appreciation $115,631,433
Gross unrealized depreciation (917,477)
Net unrealized appreciation $114,713,956
MAJOR INVESTMENT ELIMINATIONS--
July 1 to December 31, 1993
Alabama State Docks Department, Coal Revenue Refunding, 10.000%, 10/01/2005
Austin, Texas, Combined Utility System, 10.250%, 11/15/2012
Austin, Texas, Combined Utility System, 11.125% 11/15/2009
Broward County, Florida, School District, 5.700%, 02/15/2008
Cambria County, Pennsylvania, Hospital Development Authority, Conemaugh Valley
Memorial Hospital, 10.125%, 07/01/2018
City of New Orleans, Louisiana, General Obligation, 6.000%, 09/01/2021
Florida State Department Transportation Turnpike, 5.000%, 07/01/2015
Florida State Department Transportation Turnpike, 5.000%, 07/01/2019
Florida State Department Transportation Turnpike, 5.250%, 07/01/2022
Harris County, Texas, Toll Road, Multimode Senior Lien Revenue, 8.300%,
08/15/2017
Harris County, Texas, Toll Road, Unlimited Tax (and Subordinated Lien
Mortgage), 9.250%, 08/01/2014
Houston, Texas, General Obligation, 5.250%, 03/01/2009
Jacksonville, Florida, Electric Authority, 5.250%, 10/01/2021
Jacksonville, Florida, Electric Authority, 5.250%, 10/01/2028
Kissimmee, Florida, Utility Authority Electric System, 5.250%, 10/01/2018
Los Angeles Department of Water and Power, 5.375%, 09/01/2023
Lower Colorado River Authority, Texas, 5.375%, 01/01/2016
Massachusetts Bay Transportation Authority, 5.500%, 03/01/2022
Massachusetts General Obligation, Series D, 6.000%, 05/01/2008
Massachusetts State, General Obligation, 5.400%, 11/01/2006
Massachusetts State, General Obligation, 5.750%, 05/01/2012
Massachusetts State Water Resources Authority, 5.500%, 11/01/2015
Massachusetts State Water Resources Authority, 5.550%, 07/15/2022
Minneapolis Community Development Agency and St. Paul Housing and
Redevelopment Authority, Minnesota Health Care System Bonds (Health One
Obligated Group), 10.000%, 11/01/2014
Nevada Housing Finance Agency, Single Family Mortgage, 5.950%, 10/01/2011
New Jersey Health Care Facilities Financing Authority, Mountainside Hospital,
9.000%, 08/01/2025
New Mexico Mortgage Finance Authority, 6.900%, 07/01/2024
New York City, New York, General Obligation, 6.000%, 08/01/2006
North Carolina Eastern Municipal Power Agency, Power Systems, 5.500%,
01/01/2021
North Carolina Eastern Municipal Power Agency, Power Systems, 9.278%,
01/01/2025
Orlando--Orange County, Florida, Expressway Authority, 5.250%, 07/01/2014
Pennsylvania Housing Finance Agency, Single Family Mortgage, 9.625%,
10/01/2016
Pennsylvania State, General Obligation, 5.000%, 04/15/2010
Philadelphia, Pennsylvania, School District, 5.375%, 07/01/2005
Puerto Rico Commonwealth, Public Buildings Authority, 5.500%, 07/01/2021
Regional Transportation Authority, Illinois, 7.200%, 11/01/2020
Riverdale, Maryland, Hospital Facilities, Washington Adventist Hospital
Project, 11.500%, 09/01/2012
Sacramento, California, Municipal Utility District Electric, Series D, 5.250%,
11/15/2020
Salem County, New Jersey, Industrial Pollution Control Financing Authority,
Public Service Electric and Gas Co. Project, 10.375%, 09/01/2014
San Antonio, Texas, Electric and Gas, 8.000%, 02/01/2016
San Francisco, California, City and County Airport Commission, International
Airport, 6.000%, 05/01/2020
Sikeston, Missouri, Electric Authority, 6.250%, 06/01/2022
Snohomish County, Washington, Public Utility District #1, Electric Refunding,
8.000%, 01/01/2015
<PAGE>
MAJOR INVESTMENT ELIMINATIONS (continued)
Superior Wisconsin, Limited Obligation, Collateral, Midwest Energy, Series E,
6.900%, 08/01/2021
Triborough Bridge and Tunnel Authority, General Purpose, 5.000%, 01/01/2015
Tulsa, Oklahoma, Industrial Authority, Tulsa Regional Medical Center, 7.625%,
06/01/2017
University of Texas, Series B, 6.750%, 08/15/2013
Vallejo, California, Water Improvement Project, 6.500%,11/01/2014
Washington State Public Power Supply System, #2, 7.000%, 07/01/2012
Washington State Public Power Supply Systems Nuclear Project, 5.750%,
07/01/2013
Western Washington University, Housing and Dining System, 6.375%, 10/01/2022
Wisconsin State, General Obligation, 5.800%, 11/01/2009
<PAGE>
FINANCIAL HIGHLIGHTS
(For a share outstanding throughout the year)
<TABLE>
<CAPTION>
Year Ended December 31,
1993 1992 1991 1990*** 1989 1988 1987 1986 1985 1984
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Net asset value:
Beginning of
year $ 8.04 $ 8.07 $ 7.90 $ 8.06 $ 8.18 $ 8.09 $ 8.85 $ 8.31 $ 7.57 $ 7.66
Income from
investment
operations
Net investment
income 0.39 0.46 0.46 0.52 0.57 0.55 0.56 0.68 0.70 0.72
Net gains
(losses) on
securities 0.48 0.12 0.36 (0.01) 0.15 0.30 (0.58) 0.88 0.81 (0.02)
Net commissions
paid on fund
share sales * 0 0 0 0 0 0 0 (0.08) (0.07) (0.07)
Total from
investment
operations 0.87 0.58 0.82 0.51 0.72 0.85 (0.02) 1.48 1.44 0.63
Less
distributions
Dividends from
net investment
income (0.39) (0.46) (0.46) (0.52) (0.60) (0.63) (0.64) (0.68) (0.70) (0.72)
Distributions in
excess of net
investment
income ** (0.06) (0.04) (0.07) (0.03) 0 0 0 0 0 0
Distributions
from realized
capital
gains-net (0.33) (0.11) (0.12) (0.12) (0.24) (0.13) (0.10) (0.26) 0 0
Distributions in
excess of
realized capital
gains-net** (0.01) 0 0 0 0 0 0 0 0 0
Total
distributions (0.79) (0.61) (0.65) (0.67) (0.84) (0.76) (0.74) (0.94) (0.70) (0.72)
Net asset value:
End of year $ 8.12 $ 8.04 $ 8.07 $ 7.90 $ 8.06 $ 8.18 $ 8.09 $ 8.85 $ 8.31 $ 7.57
Total return**** 11.15% 7.55% 10.80% 6.66% 9.11% 10.89% (0.14%) 18.26% 19.96% 8.77%
Ratios/supplemental
data
Ratios to average
net assets:
Operating and
management
expenses 1.66% 1.38% 1.75% 1.18% 1.23% 1.79% 1.70% 0.83% 0.92% 1.08%
Net investment
income 4.72% 5.71% 5.78% 6.54% 6.94% 6.74% 6.80% 7.79% 8.65% 9.41%
Portfolio
turnover rate 76% 78% 77% 64% 69% 61% 43% 44% 55% 141%
Net assets, end
of year
(thousands) $1,548,503 $1,453,199 $1,146,185 $1,060,826 $901,912 $903,132 $894,768 $1,025,084 $863,720 $336,774
<FN>
*Prior to June 30, 1987, net commissions paid on new sales of shares under the Fund's Rule 12b-1 Distribution Plan had
been treated for both financial statement and tax purposes as capital charges. On June 11, 1987, the Securities and
Exchange Commission adopted a rule which required for financial statements for the periods ended on or after June 30,
1987, that net commissions paid under Rule 12b-1 be treated as operating expenses rather than capital charges.
Accordingly, beginning with the year ended December 31, 1987, the Fund's financial statements reflect 12b-1
Distribution Plan expenses (i.e., shareholder service fees plus commissions paid net of deferred sales charges
received by the Fund) as a component of net investment income.
**Effective January 1, 1993 the Fund adopted Statement of Position 93-2: Determination, Disclosure, and Financial
Statement Presentation of Income, Capital Gain and Return of Capital Distributions by Investment Companies. As a
result, distribution amounts exceeding book basis net investment income (or tax basis net income on a temporary basis)
are presented as "Distributions in excess of net investment income." Similarly, capital gain distributions in excess
of book basis capital gains (or tax basis capital gains on a temporary basis) are presented as "Distributions in
excess of realized capital gains." For the fiscal years ended December 31, 1992, 1991 and 1990, distributions in
excess of book basis net income were charged to paid-in capital.
***Calculation based on average shares outstanding.
****Excluding applicable sales charges.
</FN>
</TABLE>
<PAGE>
STATEMENT OF ASSETS AND LIABILITIES
December 31, 1993
Assets:
Investments at market value (identified cost-$1,394,938,828)
(Note 1) $1,509,015,149
Cash 93,141
Receivable for:
Investments sold 31,169,201
Fund shares sold 3,948,015
Interest 28,824,824
Other assets 90,794
Total assets 1,573,141,124
Liabilities (Notes 2, 4, and 5):
Payable for:
Income distribution 4,044,903
Investments purchased 19,761,837
Fund shares redeemed 637,400
Payable to Investment Advisor 50,878
Accrued reimbursable expenses 4,442
Other accrued expenses 138,325
Total liabilities 24,637,785
Net assets $1,548,503,339
Net assets represented by (Note 1):
Paid-in capital $1,432,442,494
Undistributed net investment income 1,347,562
Accumulated realized gains on investment transactions--net 636,962
Net unrealized appreciation on investments 114,076,321
Total net assets applicable to outstanding shares of
beneficial interest ($8.12 a share on 190,710,454 shares
outstanding) (Note 2) $1,548,503,339
See Notes to Financial Statements.
<PAGE>
STATEMENT OF OPERATIONS
<TABLE>
<CAPTION>
Year Ended December 31, 1993
<S> <C> <C>
Investment income (Note 1):
Interest $ 97,318,216
Expenses (Notes 2 and 4):
Investment management fee and administrative services $ 8,995,945
Accounting services 29,735
Trustees' fees and expenses 68,158
Distribution Plan expenses 16,234,601
Total expenses 25,328,439
Investment income--net (Note 1) 71,989,777
Realized and unrealized gain (loss) on investments and closed
futures contracts--net (Notes 1 and 3):
Realized gain on investments sold:
Proceeds from sales 1,122,509,383
Cost of investments sold 1,061,184,073
Realized gain on investments--net 61,325,310
Realized gain on closed futures contracts:
Proceeds on closed futures contracts 23,282,900
Cost of closed futures contracts 23,158,125
Realized gain on closed futures contracts--net 124,775
Realized gain on investments and closed futures contracts--net 61,450,085
Net unrealized appreciation (depreciation) on investments:
Beginning of year 86,695,317
End of year 114,076,321
Increase (decrease) in unrealized appreciation or depreciation on
investments 27,381,004
Net gain on investments and closed futures contracts 88,831,089
Net increase in net assets resulting from operations $160,820,866
</TABLE>
See Notes to Financial Statements.
<PAGE>
STATEMENTS OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
Year Ended December 31,
1993 1992
<S> <C> <C>
Operations:
Investment income--net (Note 1) $ 71,989,777 $ 68,539,827
Realized gain on investments and closed futures contracts--net
(Notes 1
and 3) 61,450,085 13,010,623
Increase (decrease) in unrealized appreciation or
depreciation--net 27,381,004 8,854,503
Net increase in net assets resulting from operations 160,820,866 90,404,953
Distributions to shareholders from (Notes 1 and 5):
Investment income--net (71,989,777) (68,539,827)
In excess of net investment income (11,148,339) (6,572,049)
Realized capital gains from investment transactions--net (61,329,277) (16,070,849)
In excess of realized capital gains from investment
transactions--net (1,324,888) 0
Total distributions to shareholders (145,792,281) (91,182,725)
Capital share transactions (Note 2):
Proceeds from shares sold 169,165,502 370,730,129
Payments for shares redeemed (172,689,849) (111,428,040)
Net asset value of shares issued in reinvestment of distributions
from:
Investment income--net and in excess of net investment income 43,019,252 38,066,482
Realized gain from investment transactions--net 40,780,868 10,423,287
Net increase in net assets resulting from capital share
transactions 80,275,773 307,791,858
Total increase in net assets 95,304,358 307,014,086
Net assets:
Beginning of year 1,453,198,981 1,146,184,895
End of year $1,548,503,339 $1,453,198,981
</TABLE>
See Notes to Financial Statements.
<PAGE>
NOTES TO FINANCIAL STATEMENTS
1. Significant Accounting Policies
Keystone Tax Free Fund (the "Fund") is a Massachusetts business trust for
which Keystone Management, Inc. ("KMI") is the Investment Manager and Keystone
Custodian Funds, Inc. ("Keystone") is the Investment Adviser. The Fund is
registered under the Investment Company Act of 1940 as a diversified open-end
investment company.
Keystone is a wholly-owned subsidiary of Keystone Group, Inc. ("KGI"), a
Delaware corporation. KGI is privately owned by an investor group consisting
of members of current management of Keystone. Keystone Investor Resource
Center, Inc. ("KIRC"), a wholly-owned subsidiary of Keystone, is the Fund's
transfer agent.
The following is a summary of significant accounting policies consistently
followed by the Fund in the preparation of its financial statements. The
policies are in conformity with generally accepted accounting principles.
A. Tax-exempt bonds are stated on the basis of valuations provided by a
pricing service, approved by the Board of Trustees, that uses information with
respect to transactions in bonds, quotations from bond dealers, market
transactions in comparable securities and various relationships between
securities in determining value. Non-tax-exempt securities for which market
quotations are readily available are valued at the price quoted which, in the
opinion of the Board of Trustees or their representative, most nearly
represents their market value.
Short-term investments which are purchased with maturities of sixty days or
less are valued at amortized cost (original purchase cost as adjusted for
amortization of premium or accretion of discount) which when combined with
accrued interest approximates market. Short-term investments maturing in more
than sixty days for which market quotations are readily available are valued
at current market value. Short-term investments maturing in more than sixty
days when purchased which are held on the sixtieth day prior to maturity are
valued at amortized cost (market value on the sixtieth day adjusted for
amortization of premium or accretion of discount) which when combined with
accrued interest approximates market. All other securities and other assets
are valued at fair value as determined in good faith using methods prescribed
by the Board of Trustees.
B. A futures contract is an agreement between two parties to buy and sell a
specific amount of a commodity, security, financial instrument, or, in the
case of a stock index, cash at a set price on a future date. Upon entering
into a futures contract, the Fund is required to deposit with a broker an
amount ("initial margin") equal to a certain percentage of the purchase price
indicated in the futures contract. Subsequent payments ("variation margin")
are made or received by the Fund each day, as the value of the underlying
instrument or index fluctuates, and are recorded for book purposes as
unrealized gains or losses by the Fund. For federal tax purposes, any futures
contracts which remain open at fiscal year-end are marked-to-market and the
resultant net gain or loss is included in federal taxable income.
C. Securities transactions are accounted for on the trade date. Realized gains
and losses are recorded on the identified cost basis. Interest income is
recorded on the accrual basis. All premiums and original issue discounts are
amortized/accreted for both financial reporting and federal income tax
purposes.
D. The Fund has qualified, and intends to qualify in the future, as a
regulated investment company under the Internal Revenue Code of 1986, as
amended ("Internal Revenue Code"). Thus, the Fund is relieved of any federal
income tax liability by distributing all
<PAGE>
of its net investment income and net capital gains, if any, to its
shareholders. The Fund intends to avoid excise tax liability by making the
required distributions under the Internal Revenue Code.
E. When the Fund enters into a repurchase agreement (a purchase of securities
whereby the seller agrees to repurchase the securities at a mutually agreed
upon date and price) the repurchase price of the securities will generally
equal the amount paid by the Fund plus a negotiated interest amount. The
seller under the repurchase agreement will be required to provide securities
("collateral") to the Fund whose value will be maintained at an amount not
less than the repurchase price, and which generally will be maintained at 101%
of the repurchase price. The Fund monitors the value of collateral on a daily
basis, and if the value of collateral falls below required levels, the Fund
intends to seek additional collateral from the seller or terminate the
repurchase agreement. If the seller defaults, the Fund would suffer a loss to
the extent that the proceeds from the sale of the underlying securities were
less than the repurchase price. Any such loss would be increased by any cost
incurred on disposing of such securities. If bankruptcy proceedings are
commenced against the seller under the repurchase agreement, the realization
on the collateral may be delayed or limited. Repurchase agreements entered
into by the Fund will be limited to transactions with dealers or domestic
banks believed to present minimal credit risks, and the Fund will take
constructive receipt of all securities underlying repurchase agreements until
such agreements expire.
F. The Fund distributes net investment income to shareholders monthly and net
capital gains, if any, annually. Distributions from net investment income are
determined in accordance with income tax regulations. Dividends from net
investment income can exceed the Fund's book basis net investment income.
Effective January 1, 1993, the Fund adopted Statement of Position 93-2:
Determination, Disclosure, and Financial Statement Presentation of Income,
Capital Gain and Return of Capital Distributions by Investment Companies. As a
result, the Fund changed the financial statement classification of
distributions to shareholders to more clearly reflect the differences between
financial statement amounts available for distribution and amounts distributed
to comply with income tax regulations. Accordingly, the following
reclassifications have been made to the capital accounts in the year ended
December 31, 1993; a decrease in paid-in capital of $22,347,918, an increase
in undistributed net investment income of $12,495,901, and an increase in
accumulated net realized gains (losses) on investment transactions of
$9,852,017. The significant difference between financial statement amounts
available for distribution and distributions made in accordance with income
tax regulations is due to the difference in recognition of a deduction for
12b-1 Distribution Plan charges.
2. Capital Share Transactions
The Declaration of Trust authorizes the issuance of an unlimited number of
shares of beneficial interest with no par value. Transactions in shares of the
Fund were as follows:
<PAGE>
Year Ended December 31,
1993 1992
Shares sold 20,470,708 46,460,519
Shares redeemed (20,802,266) (13,808,422)
Shares issued in reinvestment
of distributions from net
investment income and in
excess of net investment income 5,196,577 4,725,734
Realized gain-net 5,110,384 1,327,807
Net increase 9,975,403 38,705,638
The Fund bears some of the costs of selling its shares under a Distribution
Plan adopted pursuant to Rule 12b-1 under the Investment Company Act of 1940.
The Distribution Plan provides that the Fund may incur certain expenses which
may not exceed a maximum amount equal to 0.3125% of the Fund's average daily
net assets for any quarter occurring after the inception of the Distribution
Plan. Under the Distribution Plan, the Fund pays Keystone Distributors, Inc.
("KDI"), the principal underwriter and a wholly-owned subsidiary of Keystone,
amounts which in total may not exceed the Distribution Plan maximum.
In connection with the Distribution Plan and subject to the limitations
discussed below, Fund shares are offered for sale at net asset value without
any initial sales charge. From the amounts received by KDI in connection with
the Distribution Plan, and subject to the limitations discussed below, KDI
generally pays brokers or others a commission equal to 3% of the price paid to
the Funds for each sale of Fund shares as well as a shareholder service fee at
a rate of 0.25% per annum of the net asset value of the shares sold by such
brokers or others and remaining outstanding on the books of the Fund for
specified periods.
To the extent Fund shares are redeemed within four calendar years of original
issuance, the Fund may be eligible to receive a deferred sales charge from the
investor as partial reimbursement for sales commissions previously paid on
those shares. This charge is based on declining rates, which begin at 4.0%,
applied to the lesser of the net asset value of shares redeemed or the total
cost of such shares.
A new rule of the National Association of Securities Dealers, Inc. ("NASD
Rule") limits the annual expenditures, which the Fund may incur under the
Distribution Plan to 1%, of which 0.75% may be used to pay such distribution
expenses and 0.25% may be used to pay shareholder service fees. The new NASD
Rule also limits the aggregate amount which the Fund may pay for such
distribution costs to 6.25% of gross share sales since the inception of the
Fund's 12b-1 Distribution Plan, plus interest at the prime rate plus 1% on
unpaid amounts thereof (less any contingent deferred sales charges paid by the
shareholders to KDI).
The Fund has operated its Distribution Plan in accordance with both the Plan
and the NASD Rule since July 8, 1992, except that until July 7, 1993, maximum
annual payments with respect to Net Asset Value as represented by shares sold
prior to January 1, 1992 remained at the current rate of 0.3125% quarterly
(approximately 1.25% annually).
KDI intends, but is not obligated, to continue to pay or accrue distribution
charges which exceed current annual payments permitted to be received by KDI
from the Fund. KDI intends to seek full payment of such charges from the Fund
(together with annual interest thereon at the prime rate plus one percent) at
such time in the future as, and to the extent that, payment thereof by the
Fund would be within permitted limits. KDI currently intends to seek payment
of interest only on such charges paid or accrued by KDI subsequent to January
1, 1992.
<PAGE>
Commencing on July 8, 1992, contingent deferred sales charges applicable to
shares of the Fund issued after January 1, 1992 have, to the extent permitted
by the NASD Rule, been paid to KDI rather than to the Fund.
During the year ended December 31, 1993, the Fund recovered $373,564 in
deferred sales charges. During the year, the Fund paid KDI $16,608,165 under
the Distribution Plan, of which $4,272,087 represented repayment of amounts
("advances") paid by KDI during the year or in previous years in excess of
amounts received by KDI under the Distribution Plan. The amount paid by the
Fund under its Distribution Plan, net of deferred sales charges, was
$16,234,601 (1.06% of the Fund's average daily net asset value during the
year). During the year, KDI retained $9,241,496 and paid commissions on new
sales and transfer agent fees to dealers and others of $7,366,669. During the
year, KDI received $482,452 in deferred sales charges, reducing total advances
outstanding to 8,498,955 (0.55% of the Fund's net asset value as of December
31, 1993).
3. Securities Transactions
For the year ended December 31, 1993, purchases and sales of investment
securities were as follows:
Cost of Proceeds
Purchases from Sales
Tax-exempt investments $1,124,995,844 $1,122,509,383
Short-term commercial
and tax-exempt notes 697,351,597 712,860,332
$1,822,347,441 $1,835,369,715
4. Investment Management and Transactions with Affiliates
Under the terms of the Investment Management Agreement between KMI and the
Fund, dated December 29, 1989, KMI provides investment management and
administrative services to the Fund, as well as certain additional operating
services, facilities and supplies. In return, KMI is paid monthly, (i) a
management fee calculated daily at a rate of 2.0% of the Fund's gross
investment income plus an amount determined by applying percentage rates
starting at 0.50% and declining as net assets increase, to 0.25% per annum, to
the net asset value of the Fund, and (ii) an amount equal to KMI's
reimbursable expenses accrued during the year in providing such additional
services. KMI has entered into an Investment Advisory Agreement with Keystone,
dated December 30, 1989, under which Keystone provides investment advisory and
management services to the Fund and receives for its services an annual fee
representing 85% of the management fee received by KMI.
During the year ended December 31, 1993, the Fund paid or accrued to KMI
investment management and administrative services fees of $8,995,945. Included
in this amount is the management fee of $6,507,055, which represented 0.43% of
the Fund's average net assets on an annualized basis. Of such management fee
paid to KMI, $5,530,997 was paid to Keystone for its services to the Fund.
Also included in the total investment management and administrative services
fee paid by the Fund were the following approximate amounts incurred by KMI
(and reimbursed by the Fund) in providing or obtaining for the Fund the
additional operating services, facilities and supplies required by the
Agreement: transfer agent fees, $1,657,577, audit and legal fees, $95,049,
custodian fees, $422,122, printing and supplies, $93,508, and registration
fees, $141,869, and other, $78,765.
During the year ended December 31, 1993, the Fund paid or accrued to KIRC
$29,735 for certain
<PAGE>
accounting services and $1,657,577 for transfer agent fees. This amount for
transfer agent fees services is included in the payments made by KMI described
in the preceding paragraph.
5. Distributions to Shareholders
The net investment income of the Fund (interest income accrued as earned, less
expenses of the Fund) is determined as of the normal close of trading on the
New York Stock Exchange each business day on which the exchange is open. The
net investment income so determined each day is declared as a dividend to
shareholders of record at the time of such determination and is distributed
promptly after the end of each calendar month. Any net realized short-term and
long-term capital gains in excess of carried-over losses, will be distributed
annually. All distributions of net investment income will be paid in cash
unless the shareholder has directed that they be reinvested, in which case
such reinvestment will be at the net asset value on the last business day of
the month in which declared. Any distributions of capital gains will be
reinvested in additional shares of the Fund at net asset value on the record
date of the month in which declared unless the shareholder has specified that
they wish to receive cash. Shares acquired through reinvestment of net
investment income or capital gains are not subject to contingent deferred
sales charges.
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Trustees and Shareholders
Keystone Tax Free Fund
We have audited the accompanying statement of assets and liabilities of
Keystone Tax Free Fund, including the schedule of investments, as of December
31, 1993, and the related statement of operations for the year then ended, the
statements of changes in net assets for each of the years in the two-year
period then ended, and the financial highlights for each of the years in the
ten-year period then ended. These financial statements and financial
highlights are the responsibility of the Fund's management. Our responsibility
is to express an opinion on these financial statements and financial
highlights based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements and
financial highlights are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. Our procedures included confirmation of securities
owned as of December 31, 1993 by correspondence with the custodian and
brokers. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred to
above present fairly, in all material respects, the financial position of
Keystone Tax Free Fund, as of December 31, 1993, the results of its operations
for the year then ended, the changes in its net assets for each of the years
in the two-year period then ended, and the financial highlights for each of
the years in the ten-year period then ended in conformity with generally
accepted accounting principles.
KPMG PEAT MARWICK
Boston, Massachusetts
February 11, 1994
